Prospectus Supplement	Filed Pursuant to Rule 497

(To Prospectus dated June 11, 2003)	Registration Statement No. 333-104149

Allied Capital Corporation

2,200,000 Shares

Common Stock

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         We are offering for sale 2,200,000 shares of our common stock. Our common stock is traded on the New York Stock Exchange under the symbol “ALD.” The last reported sales price for our common stock on September 24, 2003 was $25.03 per share.

       You should review the information, including the risk of leverage, set forth under “Risk Factors” on page 9 of the accompanying prospectus before investing in our common stock.

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		Per Share				Total
Public offering price		$	25.00			$	55,000,000
Underwriting discount		$	1.18			$	2,596,000
Proceeds to Allied Capital Corporation(1)		$	23.82			$	52,404,000

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(1)	Before deducting expenses payable by us estimated to be $180,000.

      Please read this prospectus supplement, and the accompanying prospectus, before investing, and keep it for future reference. The prospectus supplement and the accompanying prospectus contain important information about us. The SEC maintains an Internet website (http://www.sec.gov) that contains other information about us.

      We have granted the underwriters a 30-day option to purchase up to 330,000 additional shares of common stock to cover over-allotments. If the underwriters exercise the option in full, the public offering price, the underwriting discount and proceeds to us would be $63,250,000, $2,985,400 and $60,264,600, respectively.

      Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus supplement or the accompanying prospectus. Any representation to the contrary is a criminal offense.

      The shares of common stock will be ready for delivery on or about September 30, 2003.

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Deutsche Bank Securities	U.S. Bancorp Piper Jaffray

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The date of this prospectus supplement is September 24, 2003.

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      You should rely only on the information contained in this prospectus supplement and the accompanying prospectus. We have not, and the underwriters have not, authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. We are not, and the underwriters are not, making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted. You should assume that the information appearing in this prospectus supplement and the accompanying prospectus is accurate only as of their respective dates. Our business, financial condition, results of operations and prospects may have changed since those dates.

TABLE OF CONTENTS

Prospectus Supplement

		Page
		Number
Fees and Expenses			S-1
Use of Proceeds			S-2
Underwriting			S-2
Recent Developments			S-4
Legal Matters			S-4
Interim Management’s Discussion and Analysis of Financial Condition and Results of Operations			S-5
Interim Consolidated Financial Statements			S-36
Notice Regarding Independent Accountants’ Review Report			S-72

Prospectus

Prospectus Summary			1
Fees and Expenses			5
Selected Condensed Consolidated Financial Data			6
Where You Can Find Additional Information			8
Risk Factors			9
Use of Proceeds			16
Price Range of Common Stock and Distributions			17
Management’s Discussion and Analysis of Financial Condition and Results of Operations			18
Senior Securities			45
Business			49
Legal Proceedings			66
Portfolio Companies			67
Determination of Net Asset Value			74
Management			78
Compensation of Executive Officers and Directors			84
Control Persons and Principal Holders of Securities			89
Certain Relationships and Related Party Transactions			91
Tax Status			92
Certain Government Regulations			96
Dividend Reinvestment Plan			100
Description of Capital Stock			101
Plan of Distribution			105
Legal Matters			106
Safekeeping, Transfer and Dividend Paying Agent and Registrar			106
Brokerage Allocation and Other Practices			106
Independent Public Accountants			106
Notice Regarding Arthur Andersen LLP			107
Index to Consolidated Financial Statements			F-1

(i)

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      In this prospectus supplement and the accompanying prospectus, unless otherwise indicated, “Allied Capital,” “we,” “us” or “our” refer to Allied Capital Corporation and its subsidiaries.

      Information contained in this prospectus supplement and the accompanying prospectus may contain forward-looking statements, which 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. The matters described in “Risk Factors” in the accompanying prospectus and certain other factors noted throughout this prospectus supplement and the accompanying prospectus constitute cautionary statements identifying important factors with respect to any such forward-looking statements, including certain risks and uncertainties, that could cause actual results to differ materially from those in such forward-looking statements.

(ii)

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FEES AND EXPENSES

     This table describes the various costs and expenses that an investor of our common stock will bear directly or indirectly.

Shareholders Transaction Expenses
	Sales load (as a percentage of offering price)(1)				4.72%
	Dividend reinvestment plan fees(2)				None
Annual Expenses (as a percentage of consolidated net assets attributable to common shares)(3)
	Operating expenses(4)				3.6%
	Interest payments on borrowed funds(5)				4.7%
		Total annual expenses(6)			8.3%

(1)	Represents the underwriting discounts and commissions with respect to the shares sold by Allied Capital in this offering.
(2)	The expenses of our dividend reinvestment plan are included in “Operating expenses.” We do not have a stock purchase plan. The participants in the dividend reinvestment plan will bear a pro rata share of brokerage commissions incurred with respect to open market purchases, if any. See “Dividend Reinvestment Plan” in the accompanying prospectus.
(3)	“Consolidated net assets attributable to common stock” equals net assets (i.e., total consolidated assets less total consolidated liabilities and preferred stock) at June 30, 2003.
(4)	“Operating expenses” represent our estimated operating expenses for the year ending December 31, 2003, excluding interest on indebtedness. This percentage for the year ended December 31, 2002, was 3.5%.
(5)	The “Interest payments on borrowed funds” represents our estimated interest expenses for the year ending December 31, 2003. We had outstanding borrowings of $979.7 million at June 30, 2003. This percentage for the year ended December 31, 2002, was 4.6%. See “Risk Factors” in the accompanying prospectus.
(6)	“Total annual expenses” as a percentage of consolidated net assets attributable to common stock are higher than the total annual expenses percentage would be for a company that is not leveraged. We borrow money to leverage our net assets and increase our total assets. The SEC requires that the “Total annual expenses” percentage be calculated as a percentage of net assets, rather than the total assets, including assets that have been funded with borrowed monies. If the “Total annual expenses” percentage were calculated instead as a percentage of consolidated total assets, our “Total annual expenses” would be 4.9% of consolidated total assets.

Example

     The following example, required by the SEC, demonstrates the projected dollar amount of total cumulative expenses that would be incurred over various periods with respect to a hypothetical investment in us. In calculating the following expense amounts, we assumed we would have no additional leverage and that our operating expenses would remain at the levels set forth in the table above.

		1 Year				3 Years				5 Years				10 Years
You would pay the following expenses on a $1,000 investment, assuming a 5.0% annual return		$	128			$	291			$	454			$	863

     Although the example assumes (as required by the SEC) a 5.0% annual return, our performance will vary and may result in a return of greater or less than 5.0%. In addition, while the example assumes reinvestment of all dividends and distributions at net asset value, participants in the dividend reinvestment plan may receive shares of common stock that we issue at or above net asset value or purchased by the administrator of the dividend reinvestment plan, at the market price in effect at the time, which may be higher than, at, or below net asset value. See “Dividend Reinvestment Plan” in the accompanying prospectus.

The example should not be considered a representation of future expenses, and the actual expenses may be greater or less than those shown.

S-1

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USE OF PROCEEDS

      The net proceeds from the sale of the shares of our common stock, after deducting estimated expenses of this offering, are estimated to be $52.2 million. We intend to use the net proceeds from selling our common stock for investment in the debt or equity securities of private companies, non-investment grade commercial mortgage-backed securities or collateralized debt obligation bonds and preferred shares and other general corporate purposes. We may also repay a portion of our revolving line of credit. At September 23, 2003, the interest rate on our revolving line of credit was 2.5% and there were no amounts then outstanding. This revolving line of credit terminates in April 2005 and may be extended under substantially similar terms for one additional year at our option.

UNDERWRITING

      We and the underwriters named below have entered into an underwriting agreement concerning the shares of our common stock being offered. Subject to the terms and conditions of the underwriting agreement, each underwriter has severally agreed to purchase the number of shares of common stock set forth opposite its name below. Deutsche Bank Securities Inc. is acting as the representative of U.S. Bancorp Piper Jaffray Inc.

			Number of
Underwriters			shares
Deutsche Bank Securities Inc.				1,760,000
U.S. Bancorp Piper Jaffray Inc.				440,000
	Total			2,200,000

      If the underwriters sell more shares than the total number set forth in the table above, the underwriters have a 30-day option to buy up to an additional 330,000 shares from us at the public offering price less the underwriting discounts and commissions to cover these sales. If any shares are purchased under this option, the underwriters will severally purchase shares in approximately the same proportion as set forth in the table above.

      This offering will be underwritten on a firm commitment basis. In the underwriting agreement, the underwriters agreed, subject to the terms and conditions set forth therein, to purchase the shares of common stock being sold pursuant thereto at a price per share equal to the public offering price less the underwriting discount specified on the cover page of this prospectus supplement. According to the terms of the underwriting agreement, the underwriters will either purchase all of the shares or none of them.

      The underwriters propose to offer the shares to the public initially at the public offering price set forth on the cover of this prospectus supplement. The underwriters may also offer the shares to certain dealers at the public offering price less a concession not in excess of $0.70 per share. Any of these dealers may resell any shares purchased from the underwriters to other brokers or dealers at a discount of up to $0.10 per share from the public offering price. After the commencement of the offering, the public offering price and concession may be changed by the underwriters.

      The following table provides information regarding the per share and total underwriting discounts and commissions that we will pay to the underwriters in connection with this offering. These amounts are shown assuming both no exercise and full exercise of

S-2

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		Paid by us
		No exercise				Full exercise
Per share		$	1.18			$	1.18
Total		$	2,596,000			$	2,985,400

      We estimate that the total expenses of this offering, excluding the underwriting discounts and commissions, will be approximately $180,000, which will be paid by us.

      This offering of the shares is made for delivery when, as and if accepted by the underwriters and subject to prior sale and to withdrawal, cancellation or modification of this offering without notice. The underwriters reserve the right to reject an order for the purchase of shares in whole or in part.

      We have agreed to indemnify the underwriters against certain liabilities, including liabilities under the Securities Act, and to contribute to payments the underwriters may be required to make in respect of these liabilities.

      We and certain of our executive officers have entered into a lock-up agreement with the underwriters. Under this agreement, we and these executive officers may not, without the prior written approval of Deutsche Bank Securities Inc., offer, sell, contract to sell or otherwise dispose of or hedge our common stock or securities convertible into or exchangeable for our common stock (other than the shares in this offering, issuances of common stock pursuant to the conversion or exchange of convertible securities or the exercise of warrants or options, grants of employee stock options or issuance of common stock pursuant to the exercise of such options, transactions relating to shares of common stock or other securities acquired in open market transactions after completion of this offering, or an additional issuance of equity securities through privately negotiated transactions that may or may not involve an underwriter, whether or not registered with the SEC, aggregating not more than $75 million). These restrictions will be in effect for a period of 60 days after the date of this prospectus supplement. At any time and without notice, Deutsche Bank Securities Inc. may release all or some of the securities from this lock-up agreement.

      In connection with this offering, the underwriters may purchase and sell shares of our common stock in the open market. These transactions may include stabilizing transactions, short sales and purchases to cover positions created by short sales. Stabilizing transactions consist of bids or purchases made for the purpose of preventing or retarding a decline in the market price of our common stock while this offering is in progress. Short sales involve the sale by the underwriters of a greater number of shares than they are required to purchase in this offering. Short sales may be either “covered short sales” or “naked short sales.” Covered short sales are sales made in an amount not greater than the underwriters’ over-allotment option to purchase additional shares in this offering. The underwriters may close out any covered short position by either exercising their over-allotment option or purchasing shares in the open market. In determining the source of shares to close out the covered short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the over-allotment option. Naked short sales are sales in excess of the over-allotment option. The underwriters must close out any naked short position by purchasing shares in the open market. A naked short position is more likely to

S-3

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      The underwriters also may impose a penalty bid. This occurs when one underwriter repays to the other underwriter a portion of the underwriting discount received by it because the other underwriter has repurchased shares sold by or for the account of such underwriter in stabilizing or short covering transactions.

      We have been advised by the underwriters that these transactions may be effected on the New York Stock Exchange or otherwise and, if commenced, may be discontinued at any time. Similar to other purchase activities, these activities may have the effect of raising or maintaining the market price of our shares or preventing a decline in the market price of our shares. As a result, the price of our shares may be higher than the price that might otherwise exist in the open market.

      The underwriters expect to deliver the shares through the facilities of The Depository Trust Company in New York, New York, on or about September 30, 2003. At that time, the underwriters will pay us for the shares in immediately available funds.

      In the ordinary course of business, the underwriters and/or their affiliates have in the past performed, and may continue to perform, commercial banking, financial advisory and investment banking services for us for which they have received, or may receive, customary compensation. Affiliates of the underwriters are members of the lending syndicate for our unsecured revolving line of credit.

      This offering is being conducted in compliance with Rule 2810 of the Conduct Rules of the National Association of Securities Dealers, Inc.

      The address for Deutsche Bank Securities Inc. is 60 Wall Street, 4th Floor, New York, NY 10005. The address for U.S. Bancorp Piper Jaffray Inc. is 800 Nicollet Mall, Minneapolis, MN 55402.

RECENT DEVELOPMENTS

      On September 22, 2003, one of our directors, George C. Williams, retired as a member of our board of directors.

      For the third quarter of 2003, our board of directors declared a dividend of $0.57 per share of common stock. The third quarter dividend is payable on September 26, 2003, with a record date of September 12, 2003. The shares offered by this prospectus supplement will not be entitled to the third quarter dividend.

      During the second quarter of 2003, our board of directors extended the term of all existing employment agreements with certain of our officers from June 30, 2003 to December 31, 2003. In addition, our board of directors appointed Scott Binder, one of our managing directors, to the newly created position of Chief Valuation Officer.

LEGAL MATTERS

      Certain legal matters with respect to the validity of the shares of common stock we are offering will be passed upon for us by Sutherland Asbill & Brennan LLP, Washington, D.C. Certain legal matters related to the offering will be passed upon for the underwriters by Morgan, Lewis & Bockius LLP, New York, New York.

S-4

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INTERIM MANAGEMENT’S DISCUSSION AND ANALYSIS

      The following analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the Notes thereto included herein and in the accompanying prospectus. The information herein 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:

	•	the ongoing global economic downturn;
	•	risks associated with possible disruption in our operations due to terrorism; and
	•	future regulatory actions and conditions in our operating areas.

      Financial or other information presented for private finance portfolio companies has been obtained from the portfolio company, 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 accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America.

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, buyouts, acquisitions, recapitalizations, note purchases, and bridge financings. We generally invest in private companies though, from time to time, we may invest in public companies that lack access to public capital or whose securities may not be marginable.

S-5

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      Our portfolio composition at June 30, 2003, and December 31, 2002, was as follows:

		2003				2002
Private Finance			72	%			70	%
Commercial Real Estate Finance			28	%			30	%

      Our earnings depend primarily on the level of interest and dividend income, fee income, and net gains or losses earned on our investment portfolio after deducting interest paid on borrowed capital and operating expenses. Interest income results from the stated interest rate earned on a loan and the amortization of loan origination points and discounts. The level of interest income is directly related to the balance of the interest-bearing investment portfolio 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.

S-6

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PORTFOLIO AND INVESTMENT ACTIVITY

      Total portfolio investment activity and yields at and for the three and six months ended June 30, 2003 and 2002, and at and for the year ended December 31, 2002, were as follows:

		At and for the								At and for the
		Three Months								Six Months Ended								At and for the
		Ended June 30,								June 30,								Year Ended
																		December 31,
		2003				2002				2003				2002				2002
($ in millions)
		(unaudited)								(unaudited)
Portfolio at value		$	2,546.1			$	2,381.0			$	2,546.1			$	2,381.0			$	2,488.2
Investments funded		$	257.4			$	115.5			$	526.4			$	195.5			$	506.4
Change in accrued or reinvested interest and dividends		$	9.3			$	6.2			$	20.4			$	19.5			$	44.7
Principal repayments		$	74.3			$	36.0			$	150.3			$	67.0			$	143.2
Sales		$	32.6			$	1.2			$	276.7			$	126.3			$	213.5
Yield(1)			14.1	%			13.8	%			14.1	%			13.8	%			14.0	%

(1)	The weighted average yield on interest-bearing investments is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount, and market discount earned on accruing interest-bearing investments, 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, investment activity, and yields at and for the three and six months ended June 30, 2003 and 2002, and at and for the year ended December 31, 2002, were as follows:

			At and for the								At and for the
			Three Months								Six Months Ended								At and for the
			Ended June 30,								June 30,								Year Ended
																			December 31,
			2003				2002				2003				2002				2002
($ in millions)
			(unaudited)								(unaudited)
Portfolio at value:
	Loans and debt securities		$	1,192.4			$	1,050.8			$	1,192.4			$	1,050.8			$	1,151.2
	Equity interests			646.8				584.5				646.8				584.5				592.0
Total portfolio			$	1,839.2			$	1,635.3			$	1,839.2			$	1,635.3			$	1,743.2
Investments funded			$	163.8			$	32.2			$	273.9			$	69.8			$	297.2
Change in accrued or reinvested interest and dividends			$	8.1			$	7.0			$	19.4			$	19.1			$	42.6
Principal repayments			$	70.9			$	27.2			$	146.0			$	56.0			$	129.3
Yield(1)				14.4	%			13.9	%			14.4	%			13.9	%			14.4	%

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

S-7

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     Investments funded for the six months ended June 30, 2003 and 2002, and for the year ended December 31, 2002, consisted of the following:

				Loans and
				Debt				Equity
				Securities				Interests				Total
($ in millions)
For the Six Months Ended June 30, 2003(1)
	Companies more than 25% owned			$	42.2			$	25.2			$	67.4
	Companies 5% to 25% owned				9.5				1.0				10.5
	Companies less than 5% owned				190.6				5.4				196.0
		Total		$	242.3			$	31.6			$	273.9
For the Six Months Ended June 30, 2002(1)
	Companies more than 25% owned			$	16.0			$	3.8			$	19.8
	Companies 5% to 25% owned				7.5				7.0				14.5
	Companies less than 5% owned				34.0				1.5				35.5
		Total		$	57.5			$	12.3			$	69.8
For the Year Ended December 31, 2002(1)
	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

(1)

The private finance portfolio is presented in three categories — companies more than 25% owned, which represent portfolio companies where we directly or indirectly own more than 25% of the outstanding voting securities of such portfolio company and, therefore, are deemed controlled by us under the Investment Company Act of 1940, or the 1940 Act; companies owned 5% to 25%, which represent portfolio companies where we directly or indirectly own 5% to 25% of the outstanding voting securities of such portfolio company or where we hold 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 we directly or indirectly own less than 5% of the outstanding voting securities of such portfolio company and where we have no other affiliations with such portfolio company.

     At June 30, 2003, we had outstanding funding commitments of $103.9 million to portfolio companies, including $27.4 million committed to private venture capital funds. At June 30, 2003, we also had total commitments to portfolio companies in the form of standby letters of credit and guarantees of $96.0 million.

      We fund new investments using cash, through the issuance of our common equity, 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 providing a subsequent investment.

      We may acquire more than 50% of the common stock of a company in a control buyout transaction. Control investments are generally structured such that we earn a current return through a combination of interest income on our senior loans and subordinated debt, dividends on our preferred and common stock, and management or transaction services fees to compensate us for the managerial assistance that we provide to a controlled portfolio company. We plan to continue to seek attractive control investments.

S-8

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      Business Loan Express, LLC.     At June 30, 2003, our investment in BLX totaled $264.7 million at cost and $356.8 million at value, or 12.6% of our total assets, which includes unrealized appreciation of $92.1 million.

      BLX is the nation’s second largest non-bank, government guaranteed 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 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 and originates loans under the USDA Business and Industry Guaranteed Loan Program. 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, negatively affect our financial results.

      During the quarter ended March 31, 2003, BLX completed two significant transactions, the purchase of loans and other assets from Amresco Independence Funding, Inc., or “AIF,” and the reorganization of BLX from a corporation to a limited liability company, or “LLC”.

      In January 2003, BLX completed the acquisition of $128.0 million of performing loans and other assets from AIF. BLX purchased $121.5 million of performing SBA 7(a) unguaranteed loans at par and $6.5 million of other assets. The acquisition increased BLX’s serviced portfolio and enhanced its nationwide loan origination platform. We provided $50 million of the capital to fund this acquisition. Our $50 million financing was in the form of a short-term revolving credit facility of $25 million to fund the temporary capital needs of construction loans purchased and loans pending sale, as well as $25 million of preferred equity to support the future growth potential of BLX post acquisition.

      In February 2003, BLX completed a reorganization from a corporation to a limited liability company in order to simplify its corporate structure and provide certain income tax efficiencies. In connection with the reorganization, BLX’s stated book equity increased by $43 million because we converted $43 million of our subordinated debt into preferred stock in BLX, Inc., which was exchanged for Class A equity interests in BLX, LLC. In addition, we exchanged our existing preferred stock and 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.

      Subsequent to the reorganization, BLX’s taxable earnings will flow directly to its members and we represent approximately 95% of the economic interests in the LLC. In connection with the reorganization, BLX has changed its fiscal year end to September 30.

S-9

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      Summary financial data for BLX at and for the twelve months ended June 30, 2003 and 2002, is presented below.

			For the				For the
			Twelve Months				Twelve Months
			Ended				Ended
			June 30, 2003(1)				June 30, 2002
($ in millions)
Operating Data
	Total revenue		$	109.1			$	84.6
	Net income(4)		$	7.5			$	2.3
	Earnings before interest, taxes and management fees (EBITM)(4)		$	44.4			$	43.0
Balance Sheet Data
	Total assets(2)		$	340.0			$	277.1
	Total debt		$	166.0			$	183.0
	Total owners’ equity		$	137.0			$	59.9
Other Data
	Total loan originations		$	718.1			$	565.1
	Serviced loan portfolio		$	2,165.5			$	1,372.6
	Number of loans			3,048				2,083
	Loan delinquencies(3)			8.1	%			9.4	%
Serviced Loan Portfolio by Industry
	Hotels			24	%			27	%
	Gas stations/convenience stores			18				16
	Professional and retail services			12				10
	Restaurants			9				10
	Manufacturing and industrial			9				10
	Car wash/auto repair services			7				3
	Child care and health care services			6				4
	Shrimp/fishing vessels			5				7
	Recreation			5				5
	Other			5				8
	Total			100	%			100	%

(1)	Post reorganization BLX’s fiscal year end changed to September 30. The results of operations and loan originations for the twelve months ended June 30, 2003, are not necessarily indicative of the operating results to be expected for the fiscal twelve months ending September 30, 2003.
(2)	Included in total assets is $6 million of goodwill at June 30, 2003 and 2002. There is no other goodwill on BLX’s balance sheet. We acquired 94.9% of BLC Financial Services, Inc. on December 31, 2000. “Push-down” accounting was not required with respect to this transaction; accordingly, goodwill was not recorded by BLX.
(3)	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 8.2% at June 30, 2003. SBA 7(a) loans greater than one year old at June 30, 2003, had a delinquency rate of 10.5%. BLX will from time to time grant a 90-day 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. For these reasons, BLX focuses on collateral protection for each loan in addition to the cash flow of the small business and receives personal guarantees from the principal owners of the small business.

(4)	As an LLC, BLX is generally not subject to a corporate income tax.

     For the twelve months ended June 30, 2003, BLX earned revenue of $109.1 million and EBITM of $44.4 million. EBITM was reduced by $2.3 million due to costs associated

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      BLX’s business is to originate small business loans and then sell substantially all of the loans originated for cash proceeds. Loans originated during the twelve months ended June 30, 2003, totaled $718.1 million, including loans purchased from AIF. Proceeds from loan sales during the twelve months ended June 30, 2003, totaled approximately $699.4 million. 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 has a three-year $164.0 million revolving credit facility that matures in March 2004. As the controlling equity owner in BLX, we have provided an unconditional guaranty to the revolving credit facility lenders in an amount of up to 50% of the total obligations (consisting of principal, accrued interest, and other fees) of BLX under the revolving credit facility. The amount guaranteed by us at June 30, 2003, was $53.6 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 June 30, 2003. We have provided three standby letters of credit in connection with three term securitization transactions completed by BLX totaling $25.6 million.

      BLX sells the guaranteed piece of 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 2.0% of the guaranteed loan amount. Cash premiums received from guaranteed loan sales during the twelve months ended June 30, 2003, were approximately $30.3 million in total.

      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 4.8%. In addition, BLX will sell 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 2.7% 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. BLX generally receives between 4.3% and 4.9% annually on the loans sold into the securitization pools. For the

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      When BLX sells a guaranteed piece of an SBA 7(a) loan at par, or when BLX securitizes a loan, it will record a residual interest and servicing asset together referred to as 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 will receive from the loans sold or securitized. In computing the Residual Interest, BLX discounts for the present value of future cash flows, and also makes assumptions as to future loan losses and loan prepayments which may reduce future cash flows.

      At June 30, 2003, BLX’s Residual Interest totaled $162 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 $709 million over time, with approximately $52.3 million, $51.7 million, $50.4 million, and $49.0 million (or $203.4 million in the aggregate) scheduled to be received in the next four years ending on June 30, 2004, 2005, 2006, and 2007, respectively.

      The Hillman Companies, Inc. At June 30, 2003, our investment in Hillman totaled $93.6 million at cost and $181.8 million at value, or 6.4% of total assets, which includes unrealized appreciation of $88.2 million.

      Hillman is a leading manufacturer of key making equipment and distributor of key blanks, fasteners, signage, and other small hardware components and operates in multiple channels of the retail marketplace such as hardware stores, national and regional home centers, and mass merchants. Hillman has certain patent-protected products including key duplication technology that is important to its business. Hillman’s primary operations are located in Cincinnati, Ohio.

      For the year ended December 31, 2002, Hillman had total revenue of $286.8 million, earnings before interest, taxes, depreciation, amortization, and management fees, or EBITDAM, of $50.2 million, and profits before taxes of $10.0 million. For the three months ended March 31, 2003, Hillman had total revenue of $70.0 million and EBITDAM of $10.2 million. This EBITDAM is before the write-down of $5.7 million of a note receivable related to an investment made by Hillman. For the three months ended March 31, 2003, Hillman had a loss before taxes of $6.5 million, which includes the write-down of the note receivable. The total revenue, EBITDAM, and loss before taxes for the three months ended March 31, 2003, are not necessarily indicative of the operating results to be expected for the full year. Hillman had total assets of $371.0 million and total debt of $158.6 million at March 31, 2003.

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Commercial Real Estate Finance

      The commercial real estate finance portfolio, investment activity, and yields at and for the three and six months ended June 30, 2003 and 2002, and at and for the year ended December 31, 2002, were as follows:

		At and for the																At and for the
		Three Months Ended June 30,																Six Months Ended June 30,																At and for
																																		the Year Ended
																																		December 31,
		2003								2002								2003								2002								2002
		(unaudited)																(unaudited)
($ in millions)		Value				Yield*				Value				Yield*				Value				Yield*				Value				Yield*				Value				Yield*
CMBS bonds		$	423.6				13.9	%		$	560.9				14.6	%		$	423.6				13.9	%		$	560.9				14.6	%		$	555.5				14.2	%
CDO bonds and preferred shares			167.4				16.6	%			52.5				17.2	%			167.4				16.6	%			52.5				17.2	%			52.8				17.2	%
Commercial mortgage loans			105.4				7.8	%			62.0				7.9	%			105.4				7.8	%			62.0				7.9	%			63.7				7.5	%
Residual interest			—								69.0				9.3	%			—								69.0				9.3	%			69.0				9.4	%
Real estate owned			10.5								1.3								10.5								1.3								4.0
Total portfolio		$	706.9							$	745.7							$	706.9							$	745.7							$	745.0
Investments funded		$	93.6							$	83.3							$	252.5							$	125.7							$	209.2
Change in accrued or reinvested interest		$	1.2							$	(0.8	)						$	1.0							$	0.4							$	2.1
Principal repayments		$	3.4							$	8.8							$	4.3							$	11.0							$	13.9
CMBS, CDO, and commercial real estate loan sales		$	32.6							$	1.2							$	276.7							$	126.3							$	213.5

*

The weighted average yield on the interest-bearing investments is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount, and market discount earned on accruing interest-bearing investments, 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.

     Our commercial real estate investment activity for the six months ended June 30, 2003 and 2002, and for the year ended December 31, 2002, was as follows:

			Face								Amount
			Amount				Discount				Funded
($ in millions)
For the Six Months Ended June 30, 2003
CMBS bonds			$	250.1			$	(115.7	)		$	134.4
CDO bonds and preferred shares				118.4				(0.3	)			118.1
	Total		$	368.5			$	(116.0	)		$	252.5
For the Six Months Ended June 30, 2002
CMBS bonds			$	181.4			$	(83.8	)		$	97.6
CDO preferred shares				28.0				—				28.0
Commercial mortgage loans				0.1				—				0.1
	Total		$	209.5			$	(83.8	)		$	125.7
For the Year Ended December 31, 2002
CMBS bonds			$	302.5			$	(140.2	)		$	162.3
CDO preferred shares				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

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      CMBS Bonds. During the six months ended June 30, 2003 and 2002, we invested $134.4 million in seven CMBS bond issuances and $97.6 million in three CMBS bond issuances, respectively. During the year ended December 31, 2002, we invested $162.3 million in five CMBS bond issuances.

      The underlying pools of mortgage loans that are collateral for our new investments in CMBS bonds for the six months ended June 30, 2003 and 2002, and for the year ended December 31, 2002, had respective underwritten loan to value and underwritten debt service coverage ratios as follows:

		For the Six Months Ended
		June 30,
																		For the Year Ended
		2003								2002								December 31, 2002
Loan to Value Ranges		Amount				Percentage				Amount				Percentage				Amount				Percentage
($ in millions)
Less than 60%		$	1,971.8				28	%		$	401.9				16	%		$	909.3				20	%
60-65%			527.2				8				178.7				7				287.3				6
65-70%			776.5				11				264.1				11				587.9				13
70-75%			1,217.3				18				799.5				32				1,214.5				27
75-80%			2,364.9				34				812.7				33				1,477.5				33
Greater than 80%			25.2				1				12.0				1				47.8				1
Total		$	6,882.9				100	%		$	2,468.9				100	%		$	4,524.3				100	%
Weighted average loan to value			67.1	%							70.4	%							68.5	%

		For the Six Months Ended
		June 30,
																		For the Year Ended
		2003								2002								December 31, 2002
Debt Service Coverage
Ratio(1) Ranges		Amount				Percentage				Amount				Percentage				Amount				Percentage
($ in millions)
Greater than 2.00		$	2,042.6				30	%		$	103.3				4	%		$	366.9				8	%
1.76-2.00			697.1				10				84.2				3				229.6				5
1.51-1.75			1,264.4				18				240.3				10				477.4				11
1.26-1.50			2,478.3				36				1,631.8				66				2,739.6				60
Less than 1.25			400.5				6				409.3				17				710.8				16
Total		$	6,882.9				100	%		$	2,468.9				100	%		$	4,524.3				100	%
Weighted average debt service coverage ratio			1.75								1.41								1.41

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(1)	Defined as annual net cash flow before debt service divided by annual debt service payments.

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     From time to time, we may sell lower yielding CMBS bonds rated BB+ through B in order to maximize the return on our CMBS bond portfolio. The cost basis of and 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 six months ended June 30, 2003 and 2002, and for the year ended December 31, 2002, were as follows:

		For the Six
		Months Ended								For the Year
		June 30,								Ended
										December 31,
		2003				2002				2002
($ in millions)
Cost basis		$	253.5			$	123.3			$	205.9
Sales proceeds		$	284.8			$	128.8			$	225.6
Net realized gains (net of related hedge gains or losses)		$	24.6			$	7.1			$	19.1
Weighted average yield			11.8	%			11.2	%			11.5	%

      The non-investment grade and unrated tranches of 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 generally is allocated first to the senior tranches, 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 resulting in reduced cash flows, our most subordinate tranche will bear this loss first. At June 30, 2003, our CMBS bonds were subordinate to 91% to 99% of the tranches of bonds issued in various CMBS transactions. Given that the non-investment grade CMBS bonds in which we invest are junior in priority for payment of principal and interest, 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 six months ended June 30, 2003 and 2002, and for the year ended December 31, 2002, the average discount for the CMBS bonds in which we invested was 46%.

      At June 30, 2003, and December 31, 2002, the unamortized discount related to the CMBS bond portfolio was $580.2 million and $649.5 million, respectively. At June 30, 2003, we have set aside $261.2 million of this unamortized discount to absorb potential future losses, and therefore, the yield on the CMBS bonds of 13.9% assumes that this amount will not be amortized. At June 30, 2003, the CMBS bond portfolio had a fair value of $423.6 million, which included net unrealized appreciation on the CMBS bonds of $16.1 million.

      The yield on our CMBS bond portfolio at June 30, 2003, and December 31, 2002, was 13.9% and 14.2%, respectively. The yield on the CMBS bond portfolio at any point in time will vary depending on the concentration of lower yielding BB+, BB, and BB- CMBS bonds held in the portfolio. The BB+, BB and BB- CMBS bonds totaled $147.7 million and $110.9 million and had a yield of 8.0% and 8.8% at June 30, 2003, and December 31, 2002, respectively.

      At June 30, 2003, and December 31, 2002, the underlying collateral for our CMBS bonds consisted of approximately 5,100 and 4,500 commercial mortgage loans and real estate properties owned with a total outstanding principal balance of $32.0 billion and $25.0 billion, respectively. At June 30, 2003, and December 31, 2002, 1.2% and 1.0%,

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      Collateralized Debt Obligation Bonds and Preferred Shares. The yield on our CDO bonds and preferred shares at June 30, 2003, and December 31, 2002, was 16.6% and 17.2%, respectively. The yield on the CDO portfolio at any point in time will vary depending on the amount of lower yielding BBB rated CDO bonds held in the portfolio.

      During the six months ended June 30, 2003 and 2002, and the year ended December 31, 2002, we invested in the BBB bonds and preferred shares of one, two, and three collateralized debt obligations, respectively, which are secured by investment grade unsecured debt issued by various real estate investment trusts, or REITs, and investment and non-investment grade CMBS bonds. The investment grade REIT collateral consists of debt with a cut-off balance of $1.2 billion and was issued by 39 REITs. The investment grade CMBS collateral consists of CMBS bonds with a face amount of $496.0 million issued in 41 separate CMBS transactions and the non-investment grade CMBS collateral consists of BB+, BB, BB–, B+, and B rated CMBS bonds with a face amount of $873.7 million issued in 42 separate CMBS transactions. Included in the CMBS collateral for the CDOs are $793.7 million of CMBS bonds that are senior in priority of repayment to certain lower rated CMBS bonds held by us, which were issued in 27 separate CMBS transactions.

      During the three months ended June 30, 2003, we sold $6.4 million of CDO bonds and preferred shares for a net realized loss of $85 thousand, net of the related hedge loss.

      The BBB rated bonds and the preferred shares that we own are junior in priority for payment of principal and interest to the more senior tranches of debt issued by the CDOs. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, the preferred shares will bear this loss first and then the BBB rated bonds would bear any loss after the preferred shares. At June 30, 2003, our BBB bonds and preferred shares in the CDOs were subordinate to 61% to 98% of the more senior tranches of debt issued in various CDO transactions.

Portfolio Asset Quality

      Portfolio by Grade. We employ a standard grading system for the 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.

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      At June 30, 2003, and December 31, 2002, our portfolio was graded as follows:

		At June 30, 2003								At December 31, 2002
						Percentage								Percentage
		Portfolio				of Total				Portfolio				of Total
Grade		at Value				Portfolio				at Value				Portfolio
($ in millions)
1		$	839.0				32.9	%		$	801.0				32.1	%
2			1,460.9				57.4				1,400.8				56.3
3			124.8				4.9				166.0				6.7
4			20.2				0.8				23.6				1.0
5			101.2				4.0				96.8				3.9
		$	2,546.1				100.0	%		$	2,488.2				100.0	%

      Total Grade 4 and 5 assets as a percentage of the total portfolio at value at June 30, 2003, and December 31, 2002, were 4.8% and 4.9%, respectively. Included in Grade 4 and 5 assets at June 30, 2003, and December 31, 2002, were assets totaling $32.3 million and $24.1 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 Grade 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 a troubled portfolio company in order to recover the maximum amount of our investment, but record unrealized depreciation for the expected amount of the loss when such exposure is identified.

      Loans and Debt Securities on Non-Accrual Status. Loans and debt securities on non-accrual status for which we have doubt about interest collection and are in workout status are classified as Grade 4 or 5 assets. In addition, we may not accrue interest on loans and debt securities to companies that are more than 50% owned by us from time to time if such companies are in need of additional working capital. In these situations we may choose to defer current debt service.

      For the total investment portfolio, workout loans and debt securities (which excludes equity securities that are included in the total Grade 4 and 5 assets above) not accruing interest that were classified in Grade 4 and 5 were $75.0 million and $89.1 million at value at June 30, 2003, and December 31, 2002, respectively. Included in this category were loans of $17.0 million and $13.0 million, respectively, that were secured by commercial real estate. In addition to Grade 4 and 5 assets that are in workout, loans and debt securities to companies that are more than 50% owned by us that were not accruing interest totaled $72.2 million and $63.6 million at value at June 30, 2003, and December 31, 2002, respectively, and loans and debt securities to companies that are less than 50% owned by us and were not in workout but were not accruing interest totaled $3.9 million and $7.2 million at value at June 30, 2003, and December 31, 2002, respectively.

      Loans and Debt Securities Over 90 Days Delinquent. Loans and debt securities greater than 90 days delinquent were $119.2 million and $103.1 million at value at June 30, 2003, and December 31, 2002, respectively, or 4.7% and 4.1% of the total portfolio. Included in this category were loans valued at $43.5 million and $26.0 million, respectively, that were secured by commercial real estate.

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      As a provider of long-term privately negotiated investment capital, we may defer payment of principal or interest from time to time. As a result, the amount of the portfolio that is greater than 90 days delinquent or on non-accrual status may vary from quarter to quarter. The nature of our private finance portfolio company relationships frequently provide an opportunity for portfolio companies 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. 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 investments for a total return including interest or dividends plus capital gains from the sale of equity securities. Therefore, the amount of loans greater than 90 days delinquent or on non-accrual status 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.

Hedging Activities

      Because we invest in BB+ through B rated CMBS bonds and BBB rated CDO bonds that were purchased at prices 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 these CMBS and CDO bonds. These transactions, referred to as short sales, involved receiving the proceeds from the short sales of borrowed Treasury securities, with the obligations 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, which are limited only by the increase in value of the borrowed Treasury securities; conversely, the value of the 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 only by the decline in value of the borrowed Treasury securities; conversely, the value of the 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 $157.0 million and $197.0 million at June 30, 2003, and December 31, 2002, respectively, which included unrealized depreciation on the obligations of $3.9 million and $7.1 million, respectively, due to changes in the yield on the borrowed Treasury securities. The net proceeds related to the sales of the borrowed Treasury securities were $152.2 million and $189.3 million at June 30, 2003, and December 31, 2002, respectively. Under the terms of the transactions, we have provided additional cash collateral of $5.1 million and $5.4 million at June 30, 2003, and December 31, 2002, respectively, for the difference between the net proceeds related to the sales of the borrowed Treasury securities and the obligations to replenish the securities on the weekly settlement date, which is included in deposits of proceeds from sales of borrowed Treasury securities in the accompanying financial statements. The amount of the hedge will vary from period to period depending upon the amount of BB+ through B rated CMBS bonds and BBB rated CDO bonds that we own and have hedged on the balance sheet date.

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RESULTS OF OPERATIONS

Comparison of Three Months Ended June 30, 2003 and 2002

      The following table summarizes the Company’s operating results for the three months ended June 30, 2003 and 2002.

				For the Three
				Months Ended
				June 30,
																Percentage
				2003				2002				Change				Change
($ in thousands, except per share amounts)
				(unaudited)
Interest and Related Portfolio Income
	Interest and dividends			$	67,137			$	62,692			$	4,445				7	%
	Premiums from loan dispositions				1,637				46				1,591				**
	Fees and other income				8,440				10,455				(2,015	)			(19	)%
		Total interest and related portfolio income			77,214				73,193				4,021				5	%
Expenses
	Interest				19,358				17,515				1,843				11	%
	Employee				9,258				8,274				984				12	%
	Administrative				5,081				4,843				238				5	%
		Total operating expenses			33,697				30,632				3,065				10	%
Net investment income before income taxes					43,517				42,561				956				2	%
Income tax benefit					(1,081	)			—				(1,081	)			**
Net investment income					44,598				42,561				2,037				5	%
Net Realized and Unrealized Gains (Losses)
	Net realized gains (losses)				8,540				(755	)			9,295				*
	Net change in unrealized appreciation or depreciation				6,802				31,648				(24,846	)			*
		Total net gains (losses)			15,342				30,893				(15,551	)			*
Net income				$	59,940			$	73,454			$	(13,514	)			(18	)%
Diluted earnings per common share				$	0.52			$	0.71			$	(0.19	)			(27	)%
Weighted average common shares outstanding — diluted					114,552				103,440				11,112				11	%

*	Net realized gains and losses and net change in unrealized appreciation or depreciation can fluctuate significantly from period to period. As a result, quarterly comparisons of net gains and losses may not be meaningful.
**	Percentage change is not meaningful.

     Net income results from total interest and related portfolio income earned, less total expenses incurred in our operations, plus or minus net gains or losses.

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

      The level of interest income is directly related to the balance of the interest-bearing investment portfolio multiplied by the weighted average yield. The weighted average yield varies from period to period based on the current stated interest rate earned on interest-bearing investments and the amount of loans and debt securities for which interest is not accruing. Our interest-bearing investments in the portfolio increased by 5.7% to $1,899.3 million at June 30, 2003, from $1,796.5 million at June 30, 2002. The weighted

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($ in millions)		2003				2002
Interest-bearing portfolio		$	1,899.3			$	1,796.5
Portfolio yield			14.1	%			13.8	%

      Included in premiums from loan dispositions are prepayment premiums of $1.6 million and $46 thousand for the three months ended June 30, 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. Because we seek to finance primarily seasoned, performing companies, such companies at times can secure lower cost financing as their balance sheets strengthen, or as more favorable interest rates become available, or a company may enter into a transaction that results in the early repayment of their debt to us. Therefore, we generally structure our loans to require a prepayment premium for the first three to five years of the loan.

      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, information technology, web site development, marketing, human resources, personnel recruiting, board recruiting, corporate governance, and risk management.

      Fees and other income for the quarters ended June 30, 2003 and 2002, primarily included fees of $3.1 million and $2.6 million, respectively, related to structuring and diligence; fees of $0.8 million and $1.8 million, respectively, related to transaction and other services provided to portfolio companies; and fees of $4.3 million and $6.0 million, respectively, related to management services provided to portfolio companies, other advisory services, and guaranty fees. Fees and other income are generally related to specific transactions or services, and therefore may vary substantially from period to period depending on the level and types of services provided. Points or loan origination fees that represent yield enhancement on a loan are capitalized and amortized into interest income over the life of the loan.

      Business Loan Express and Hillman are our most significant portfolio investments and together represented 19.0% of our total assets at June 30, 2003. Total interest and related portfolio income earned from these investments for the three months ended June 30, 2003 and 2002, were $12.1 million and $12.2 million, respectively. In July 2002, we sold WyoTech Acquisition Corporation, which was a significant portfolio investment during 2002. Total interest and related portfolio income earned on this investment for the three months ended June 30, 2002, was $1.8 million.

      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 three months ended June 30, 2003 and 2002, were attributable to changes in the level of our borrowings under various notes payable and

S-20

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		At and for the
		Three Months
		Ended
		June 30,
		2003				2002
($ in millions)
Total Outstanding Debt		$	979.7			$	1,009.0
Average Outstanding Debt		$	962.3			$	942.3
Weighted Average Cost			7.4%				7.2%
BDC Asset Coverage*			286%				256%

*	As a BDC, the Company is generally required to maintain a minimum ratio of 200% of total assets to total borrowings.

      Employee expenses include salaries and employee benefits. The change in employee expenses 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 116 and 103 at June 30, 2003 and 2002, respectively. We no longer provide loans to our employees to exercise stock options because of recent legislation. This was an important benefit to our employees and as a result, we are considering compensation alternatives and expect to have a new program in place by the end of 2003.

      Administrative expenses include the leases for our headquarters in Washington, DC, and our regional offices, travel costs, stock record expenses, directors’ fees, legal and accounting fees, insurance premiums, and various other expenses.

      Income Tax Benefit. The Company’s wholly owned subsidiary, AC Corp, is a corporation subject to federal and state income taxes and records a benefit or expense for income taxes as appropriate. For the three months ended June 30, 2003, we recorded a tax benefit of $1.1 million as a result of AC Corp’s operating loss for the period.

      Realized Gains and Losses. Net realized gains result from the sale of equity securities associated with certain private finance investments, the sale of CMBS bonds, 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 three months ended June 30, 2003 and 2002, were as follows:

		For the
		Three Months
		Ended
		June 30,
($ in millions)		2003				2002
Realized gains		$	12.7			$	2.5
Realized losses			(4.2	)			(3.3	)
Net realized gains (losses)		$	8.5			$	(0.8	)

      Realized gains and losses for the three months ended June 30, 2003, resulted from various private finance and commercial real estate finance transactions. Realized gains for the three months ended June 30, 2003, primarily resulted from transactions involving three

S-21

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      Realized losses for the three months ended June 30, 2003, primarily resulted from one transaction involving North American Archery, LLC ($2.1 million), and two transactions involving commercial mortgage loans ($2.0 million). For the three months ended June 30, 2003 and 2002, we reversed previously recorded unrealized depreciation totaling $4.7 million and $2.0 million, respectively, when losses were realized. When we exit an investment and realize a loss, we make an accounting entry to reverse any unrealized depreciation we had previously recorded to reflect the depreciated value of the investment.

      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. At June 30, 2003, approximately 89% of our total assets represented portfolio investments recorded at fair value. 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. 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 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.

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      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 monthly 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 accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America. 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 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 are determined based on various

S-23

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      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, which utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable market yields for similar CMBS bonds and CDO bonds and preferred shares. Our assumption with regard to discount rate is based on the yield of comparable securities. 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 estimates of future credit losses, actual losses incurred, or actual and estimated prepayment speeds. 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. We recognize unrealized appreciation or depreciation on our CMBS and CDO bonds and preferred shares as comparable yields in the market change and based on changes in estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool.

      For the portfolio, net change in unrealized appreciation or depreciation for the three months ended June 30, 2003 and 2002, consisted of the following:

		2003(1)				2002(1)
($ in millions)
Net unrealized appreciation or depreciation			$10.0			$	31.7
Reversal of previously recorded unrealized appreciation associated with realized gains			(7.9	)			(2.1	)
Reversal of previously recorded unrealized depreciation associated with realized losses			4.7				2.0
Net change in unrealized appreciation or depreciation			$6.8			$	31.6

(1)	The net change in unrealized appreciation or depreciation can fluctuate significantly from period to period. As a result quarterly comparisons may not be meaningful.

     Our two most significant portfolio investments are in BLX and Hillman. The following is a simplified summary of the methodology that we used to determine the fair value of these investments.

      Business Loan Express, LLC. The most significant change in the value of our portfolio this quarter was in our investment in BLX, which increased in value by $50.5 million. BLX continues to make solid progress in its business. EBITM increased by 11.6% for the twelve months ended June 30, 2003, as compared to the twelve months ended June 30, 2002, adjusted for certain non-recurring expenses and the expense of equity appreciation rights. In addition, BLX has significantly strengthened its loan origination platform by increasing its preferred lender designation to 74 out of 79 SBA markets and as a result of the AIF acquisition.

      To determine the value of our investment in BLX at June 30, 2003, we performed four separate valuation analyses to determine its enterprise value: (1) analysis of

S-24

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      The 27% increase in the value of the Class B and Class C equity interests is a result of BLX’s continued progress as well as the fact that there has been an overall increase in the market valuations for financial services companies during the quarter. We benchmarked the valuation of BLX against a public comparable group consisting of six public financial services companies, and during this quarter the median trailing price to earnings ratio for this comparable group increased by 29% and the median forward price to earnings ratio for this comparable group increased by 52%. The increases in the comparable group market valuations indicate that the fair value of BLX has increased by current market standards.

      At a value of $262.7 million for the Class B and Class C equity interests, we are valuing BLX at a trailing price to pro-forma earnings ratio of approximately 10.5 times and on a forward projected price to pro-forma earnings ratio of approximately 9.4 times. The fair value of BLX’s Class B and Class C equity interests is at a multiple of investor cost basis of 1.6 times.

      The Hillman Companies, Inc. In performing our valuation analysis of Hillman at June 30, 2003, we determined normalized 2003 EBITDAM to be approximately $61.5 million. We believe the current enterprise value for Hillman is approximately $430.5 million, or 7.0 times 2003 normalized EBITDAM of $61.5 million. The multiple was determined by obtaining a range of multiples representing the multiple of enterprise value to EBITDA for comparable public companies and the multiple of enterprise value to EBITDA for acquisition transactions involving companies in Hillman’s peer group. From this market comparable analysis, we selected a 7.0 times multiple for our valuation. Using an enterprise value of $430.5 million, the value of our equity investment in Hillman is approximately $138.8 million, or $88.2 million greater than our cost basis of $50.6 million at June 30, 2003.

      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 common shares used to compute diluted earnings per common share, which were 114.6 million and 103.4 million for the three months ended June 30, 2003 and 2002, respectively.

OTHER MATTERS

      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. As long as we qualify as a regulated investment company, we are not taxed on our investment company taxable income or realized capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to shareholders on a timely basis. Annual tax distributions generally differ from net income for the fiscal year due to temporary and permanent timing differences in the recognition of income and expenses,

S-25

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      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 investment diversification requirements as defined in the Internal Revenue Code; and (4) distribute annually to shareholders at least 90% of our investment company taxable income as defined in the Internal Revenue 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.

S-26

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RESULTS OF OPERATIONS

Comparison of Six Months Ended June 30, 2003 and 2002

      The following table summarizes our condensed operating results for the six months ended June 30, 2003 and 2002.

				For the Six
				Months Ended
				June 30,
																Percentage
				2003				2002				Change				Change
($ in thousands, except per share amounts)
				(unaudited)
Interest and Related Portfolio Income
	Interest and dividends			$	132,658			$	127,665			$	4,993				4	%
	Premiums from loan dispositions				2,758				1,659				1,099				66	%
	Fees and other income				14,928				26,260				(11,332	)			(43	)%
		Total interest and related portfolio income			150,344				155,584				(5,240	)			(3	)%
Expenses
	Interest				37,280				34,984				2,296				7	%
	Employee				17,379				16,309				1,070				7	%
	Administrative				9,498				7,861				1,637				21	%
		Total operating expenses			64,157				59,154				5,003				8	%
Net investment income before income taxes					86,187				96,430				(10,243	)			(11	)%
Income tax benefit					(1,081	)			—				(1,081	)				**
Net investment income					87,268				96,430				(9,162	)			(10	)%
Net Realized and Unrealized Gains (Losses)
	Net realized gains (losses)				56,879				8,850				48,029					*
	Net change in unrealized appreciation or depreciation				(64,334	)			24,135				(88,469	)				*
		Total net gains (losses)			(7,455	)			32,985				(40,440	)				*
Net income				$	79,813			$	129,415			$	(49,602	)			(38	)%
Diluted earnings per common share				$	0.71			$	1.26			$	(0.55	)			(44	)%
Weighted average common shares outstanding — diluted					112,291				102,900				9,391				9	%

*	Net realized gains and losses and net change in unrealized appreciation or depreciation can fluctuate significantly from period to period. As a result, year-to-date comparisons of net gains and losses may not be meaningful.

**	Percentage change is not meaningful.

     Net income results from total interest and related portfolio income earned, less total expenses incurred in our operations, plus or minus net gains or losses.

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

      The level of interest income is directly related to the balance of the interest-bearing investment portfolio multiplied by the weighted average yield. The weighted average yield varies from period to period based on the current stated interest rate earned on interest-bearing investments and the amount of loans and debt securities for which interest is not

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($ in millions)		2003				2002
Interest-bearing portfolio		$	1,899.3			$	1,796.5
Portfolio yield			14.1	%			13.8	%

      Included in premiums from loan dispositions are prepayment premiums of $2.8 million and $1.6 million for the six months ended June 30, 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. Because we seek to finance primarily seasoned, performing companies, such companies at times can secure lower cost financing as their balance sheets strengthen, or as more favorable interest rates become available or a company may enter into a transaction that results in early repayment of their debt to us. Therefore, we generally structure our loans to require a prepayment premium for the first three to five years of the loan.

      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, information technology, web site development, marketing, human resources, personnel recruiting, board recruiting, corporate governance, and risk management.

      Fees and other income for the six months ended June 30, 2003 and 2002, included fees of $3.4 million and $10.6 million, respectively, related to structuring and diligence, fees of $1.2 million and $3.8 million, respectively, related to transaction and other services provided to portfolio companies, and fees of $9.9 million and $11.7 million, related to management services provided to portfolio companies, other advisory services and guaranty fees. Fees and other income are generally related to specific transactions or services, and therefore may vary substantially from period to period depending on the level and types of services provided. Points or loan origination fees that represent yield enhancement on a loan are capitalized and amortized into interest income over the life of the loan.

      Business Loan Express and Hillman are our most significant portfolio investments and together represented 19.0% of our total assets at June 30, 2003. Total interest and related portfolio income earned from these investments for the six months ended June 30, 2003 and 2002, was $27.5 million and $24.5 million, respectively. Total interest and related portfolio income earned from WyoTech for the six months ended June 30, 2002 was $3.6 million, which no longer occurred after the sale of the investment on July 1, 2002.

      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 six months ended June 30, 2003 and 2002, were attributable to changes in the level of our borrowings under various notes payable and debentures and

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		At and for the
		Six Months Ended
		June 30,
		2003				2002
($ in millions)
Total Outstanding Debt		$	979.7			$	1,009.0
Average Outstanding Debt		$	927.0			$	940.4
Weighted Average Cost			7.4%				7.2%
BDC Asset Coverage*			286%				256%

*	As a business development company, we are generally required to maintain a minimum ratio of 200% of total assets to total borrowings.

      Employee expenses include salaries and employee benefits. The change in employee expenses 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 116 and 103 at June 30, 2003 and 2002, respectively. We no longer provide loans to our employees to exercise stock options because of recent legislation. This was an important benefit to our employees and as a result, we are considering compensation alternatives and expect to have a new program in place by the end of 2003.

      Administrative expenses include the leases for our headquarters in Washington, DC, and our regional offices, travel costs, stock record expenses, directors’ fees, legal and accounting fees, insurance premiums, and various other expenses. The increase in administrative expenses as compared to the six months ended June 30, 2002, includes approximately $0.8 million from directors’ fees, legal and accounting fees, and consulting fees, and $0.8 million due to increased costs for corporate liability insurance.

      Income Tax Benefit. The Company’s wholly owned subsidiary, AC Corp, is a corporation subject to federal and state income taxes and records a benefit or expense for income taxes as appropriate. For the six months ended June 30, 2003, we recorded a tax benefit of $1.1 million as a result of AC Corp’s operating loss for the period.

      Realized Gains and Losses. Net realized gains result from the sale of equity securities associated with certain private finance investments, the sale of CMBS bonds, 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 six months ended June 30, 2003 and 2002, were as follows:

		For the Six
		Months Ended
		June 30,
		2003				2002
($ in millions)
Realized gains		$	61.3			$	15.4
Realized losses			(4.4	)			(6.5	)
Net realized gains		$	56.9			$	8.9

      Realized gains and losses for the six months ended June 30, 2003, resulted from various private finance and commercial real estate finance transactions. Realized gains for the six months ended June 30, 2003, primarily resulted from transactions involving seven private finance portfolio companies, including Morton Grove Pharmaceuticals, Inc.

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      Realized losses for the six months ended June 30, 2003, primarily resulted from one transaction involving North American Archery, LLC ($2.1 million), and two transactions involving commercial mortgage loans ($2.0 million). For the six months ended June 30, 2003 and 2002, we reversed previously recorded unrealized depreciation totaling $4.9 million and $5.2 million, respectively, when losses were realized. When we exit an investment and realize a loss, we make an accounting entry to reverse any unrealized depreciation we had previously recorded to reflect the depreciated value of the investment.

      Change in Unrealized Appreciation or Depreciation. For a discussion of our fair value methodology and how it affects the net change in unrealized appreciation or depreciation, see “Change in Unrealized Appreciation or Depreciation” included in the “Comparison of Three Months Ended June 30, 2003 and 2002.”

      For the portfolio, net change in unrealized appreciation or depreciation for the six months ended June 30, 2003 and 2002, consisted of the following:

		2003(1)				2002(1)
($ in millions)
Net unrealized appreciation or depreciation		$	(18.4	)		$	26.2
Reversal of previously recorded unrealized appreciation associated with realized gains			(50.8	)			(7.3	)
Reversal of previously recorded unrealized depreciation associated with realized losses			4.9				5.2
Net change in unrealized appreciation or depreciation		$	(64.3	)		$	24.1

(1)	The net change in unrealized appreciation or depreciation can fluctuate significantly from period to period. As a result year-to-date comparisons may not be meaningful.

     Net change in unrealized appreciation or depreciation for the six months ended June 30, 2003 included those discussed under the caption “Change in Unrealized Appreciation or Depreciation” included in the “Comparison of Three Months Ended June 30, 2003 and 2002.”

      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 common shares used to compute diluted earnings per common share, which were 112.3 million and 102.9 million for the six months ended June 30, 2003 and 2002, respectively.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Equivalents

      At June 30, 2003, we had $7.5 million in cash and cash equivalents. We invest otherwise uninvested cash in U.S. government- or agency-issued or guaranteed securities that are backed by the full faith and credit of the United States, or in high quality, short-term repurchase agreements fully collateralized by such securities. Our objective is to

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Debt

      At June 30, 2003, we had outstanding debt as follows:

												Annual
				Facility				Amount				Interest
				Amount				Outstanding				Cost(1)
($ in millions)
Notes payable and debentures:
	Unsecured long-term notes			$	854.0			$	854.0				7.2%
	SBA debentures				101.8				94.5				8.1%
	OPIC loan				5.7				5.7				6.6%
		Total notes payable and debentures			961.5				954.2				7.3%
Revolving line of credit					462.5				25.5				11.7	%(2)
		Total debt		$	1,424.0			$	979.7				7.4%

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(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.
(2)	The current interest rate payable on the revolving line of credit is 2.6%, which excludes the annual cost of commitment fees and other facility fees of $2.3 million.

      Unsecured Long-Term Notes. 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 2004. The notes require payment of interest only semi-annually, and all principal is due upon maturity. On May 14, 2003, we issued $153 million of five-year and $147 million of seven-year unsecured long-term notes, primarily to insurance companies. The five- and seven-year notes have fixed interest rates of 5.45% and 6.05%, respectively, and have substantially the same terms as our existing unsecured long-term notes. On May 30, 2003, $140 million of our existing unsecured long-term notes matured and we used the proceeds from the new long-term note issuance to repay this amount.

      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. Under the small business investment company program, we may borrow up to $113.4 million from the Small Business Administration. At June 30, 2003, 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 a $462.5 million unsecured revolving line of credit that expires in April 2005, with the right to extend maturity for one additional year at our option under substantially similar terms. The revolving line of credit may be expanded through new or additional commitments up to $600 million at our option. As of June 30, 2003, $399.9 million remained unused and available, net of amounts committed for standby letters of credit of $37.1 million issued under the line of credit facility. Net repayments on the revolving line of credit for the six months ended June 30, 2003, were $178.8 million. The credit facility bears interest at a rate equal to (i) the one-month LIBOR plus 1.25%, (ii) the Bank of America, N.A. prime rate, or (iii) the Federal Funds rate plus 0.50% at our option. The line of credit generally requires monthly payments of interest, and all principal is due upon maturity.

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      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 June 30, 2003, we were in compliance with these covenants.

      The following table shows our significant contractual obligations as of June 30, 2003.

							Payments Due By Year
																											After
($ in millions)			Total				2003				2004				2005				2006				2007				2007
Notes payable and debentures:
	Unsecured long-term notes		$	854.0			$	—			$	214.0			$	165.0			$	175.0			$	—			$	300.0
	Small Business Administration debentures			94.5				—				7.0				14.0				—				—				73.5
	Overseas Private Investment Corporation loan			5.7				—				—				—				5.7				—				—
Revolving line of credit(1)				25.5				—				—				—				25.5				—				—
Operating Leases				19.7				1.3				2.7				2.7				2.6				2.5				7.9
Total contractual obligations			$	999.4			$	1.3			$	223.7			$	181.7			$	208.8			$	2.5			$	381.4

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(1)

The revolving line of credit expires in April 2005 and may be extended under substantially similar terms for one additional year at our option. We assume that we would exercise our option to extend the revolving line of credit resulting in an assumed maturity of April 2006. At June 30, 2003, $399.9 million remains unused and available, net of amounts committed for standby letters of credit of $37.1 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 June 30, 2003.

						Amount of Commitment Expiration Per Year
																										After
($ in millions)		Total				2003				2004				2005				2006				2007				2007
Guarantees		$	58.9			$	0.4			$	54.3			$	0.4			$	0.1			$	0.1			$	3.6
Standby letters of credit			37.1				—				—				4.5				32.6				—				—
Total commitments		$	96.0			$	0.4			$	54.3			$	4.9			$	32.7			$	0.1			$	3.6

Equity Capital and Dividends

      Because we are a regulated investment company, we distribute our income and require external capital for growth. Because we are a business development company, we are limited in the amount of debt capital we may use to fund our growth, since we are generally required to maintain a minimum ratio of 200% of total assets to total borrowings, or approximately a 1 to 1 debt to equity ratio. At June 30, 2003, our asset coverage for senior indebtedness was 286% and our debt to equity ratio was 0.59 to 1.00.

      To support our growth during the six months ended June 30, 2003 and 2002, we raised $145.1 million and $49.9 million, respectively, in new equity capital. In July 2003, we raised an additional $9.7 million in new equity capital. We issue equity from time to time when we have attractive investment opportunities. In addition, we raised $3.3 million and $3.1 million in new equity capital through the issuance of shares through our dividend reinvestment plan during the six months ended June 30, 2003 and 2002, respectively. During the six months ended June 30, 2003, total shareholder’s equity had increased 6.8% to $1.7 billion.

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      Our Board of Directors reviews the dividend rate quarterly, and may adjust the quarterly dividend throughout the year. For the first, second and third quarters of 2003, the Board of Directors declared a dividend of $0.57 per common share. The third quarter dividend is payable on September 26, 2003, with a record date of September 12, 2003. Dividends are paid based on our taxable income, which includes our taxable interest and fee income as well as taxable net realized capital gains. Our Board of Directors evaluates whether to retain or distribute capital gains on an annual basis. Our dividend policy allows us to continue to distribute capital gains, but will also allow us to retain gains to support future growth.

      Liquidity and Capital Resources. We plan to maintain a strategy of financing our business and related debt maturities with cash from operations, through borrowings under short- or long-term credit facilities or other debt securities, through asset sales, or through the sale or issuance of new equity capital. The need for private investment capital has increased in 2003 and we have funded new investments totaling $526.4 million for the six months ended June 30, 2003, as compared to $506.4 million for the year ended December 31, 2002. Although there can be no assurance that we will secure new investments, we plan to raise new debt and equity capital as appropriate to fund investment growth.

      Dividends to shareholders for the six months ended June 30, 2003 and 2002, were $127.5 million and $109.5 million, respectively. Cash flow from operations before new investments has historically been sufficient to finance our operating expenses and pay dividends to shareholders.

      We maintain a matched-funding philosophy 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, which may or may not result in temporary differences in the matching of estimated maturities. We evaluate our interest rate exposure on an ongoing basis. To the extent deemed necessary, we may hedge variable and short-term interest rate exposure through interest rate swaps or other techniques.

      At June 30, 2003, our debt to equity ratio was 0.59 to 1.00 and our weighted average cost of funds was 7.4%. Availability on the revolving line of credit, net of amounts committed for standby letters of credit issued under the line of credit facility, was $399.9 million on June 30, 2003. We believe that we have access to capital sufficient to fund our ongoing investment and operating activities.

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 CDOs. Our investments are generally subject to restrictions on resale and generally have no established trading market. We value substantially all of our

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        Loans and Debt Securities. For loans and debt securities, fair value generally approximates cost unless the borrower’s enterprise value or 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 classified as Grade 4 or 5 assets 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 if such companies are in need of additional working capital. Loan origination fees, original issue discount, and market discount are capitalized and then amortized into interest income using the effective interest method. Prepayment premiums are recorded on loans when received.

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

        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 or other liquidation events. The determined fair values are generally discounted to account for restrictions on resale and minority ownership positions.

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      The value of our equity interests in public companies for which market quotations are readily available is based upon 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 market yields for similar CMBS bonds and CDO bonds and preferred shares. 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 estimates of future credit losses, actual losses incurred, or actual and estimated prepayment speeds. 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. We recognize unrealized appreciation or depreciation on our CMBS bonds and CDO bonds and preferred shares as comparable yields in the market change and based on changes in estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool.

      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.

      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 investment 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 investment advisory services fees are generally recognized as income as the services are rendered.

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INTERIM CONSOLIDATED FINANCIAL STATEMENTS

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

					June 30,				December 31,
					2003				2002
(in thousands, except share and per share amounts)					(unaudited)
ASSETS
Portfolio at value:
	Private finance
		Companies more than 25% owned (cost: 2003-$694,891; 2002-$628,535)			$	803,794			$	710,587
		Companies 5% to 25% owned (cost: 2003-$202,942; 2002-$219,124)				222,143				255,677
		Companies less than 5% owned (cost: 2003-$946,750; 2002-$863,243)				813,307				776,951
			Total private finance			1,839,244				1,743,215
	Commercial real estate finance (cost: 2003-$702,887; 2002-$718,312)					706,896				744,952
			Total portfolio at value			2,546,140				2,488,167
Other assets						118,698				100,221
Deposits of proceeds from sales of borrowed Treasury securities						157,262				194,745
Cash and cash equivalents						7,484				11,186
			Total assets		$	2,829,584			$	2,794,319
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
	Notes payable and debentures				$	954,200			$	794,200
	Revolving line of credit					25,500				204,250
	Obligations to replenish borrowed Treasury securities					156,986				197,027
	Accounts payable and other liabilities					34,755				45,771
			Total liabilities			1,171,441				1,241,248
Commitments and contingencies
Preferred stock						7,000				7,000
Shareholders’ equity:
	Common stock, $0.0001 par value, 200,000,000 shares authorized; 116,034,030 and 108,698,409 shares issued and outstanding at June 30, 2003, and December 31, 2002, respectively					12				11
	Additional paid-in capital					1,698,307				1,547,183
	Notes receivable from sale of common stock					(22,985	)			(24,704	)
	Net unrealized appreciation (depreciation) on portfolio					(24,923	)			39,411
	Undistributed (distributions in excess of) earnings					732				(15,830	)
			Total shareholders’ equity			1,651,143				1,546,071
			Total liabilities and shareholders’ equity		$	2,829,584			$	2,794,319
Net asset value per common share					$	14.23			$	14.22

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

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF OPERATIONS

					For the Three Months								For the Six Months
					Ended June 30,								Ended June 30,
					2003				2002				2003				2002
(in thousands, except per share amounts)
					(unaudited)								(unaudited)
Interest and Related Portfolio Income:
	Interest and dividends
		Companies more than 25% owned			$	12,728			$	9,374			$	27,931			$	18,847
		Companies 5% to 25% owned				6,480				7,581				12,973				15,021
		Companies less than 5% owned				47,929				45,737				91,754				93,797
			Total interest and dividends			67,137				62,692				132,658				127,665
	Premiums from loan dispositions
		Companies more than 25% owned				—				—				108				—
		Companies 5% to 25% owned				140				—				625				—
		Companies less than 5% owned				1,497				46				2,025				1,659
			Total premiums from loan dispositions			1,637				46				2,758				1,659
	Fees and other income
		Companies more than 25% owned				4,304				6,954				10,013				13,929
		Companies 5% to 25% owned				177				415				230				415
		Companies less than 5% owned				3,959				3,086				4,685				11,916
			Total fees and other income			8,440				10,455				14,928				26,260
			Total interest and related portfolio income			77,214				73,193				150,344				155,584
Expenses:
	Interest					19,358				17,515				37,280				34,984
	Employee					9,258				8,274				17,379				16,309
	Administrative					5,081				4,843				9,498				7,861
			Total operating expenses			33,697				30,632				64,157				59,154
Net investment income before income taxes						43,517				42,561				86,187				96,430
Income tax benefit						(1,081	)			—				(1,081	)			—
Net investment income						44,598				42,561				87,268				96,430
Net Realized and Unrealized Gains (Losses):
	Net realized gains (losses)
		Companies more than 25% owned				1,314				(630	)			1,314				(630	)
		Companies 5% to 25% owned				—				—				16,688				718
		Companies less than 5% owned				7,226				(125	)			38,877				8,762
			Total net realized gains (losses)			8,540				(755	)			56,879				8,850
	Net change in unrealized appreciation or depreciation					6,802				31,648				(64,334	)			24,135
			Total net gains (losses)			15,342				30,893				(7,455	)			32,985
Net increase in net assets resulting from operations					$	59,940			$	73,454			$	79,813			$	129,415
Basic earnings per common share					$	0.53			$	0.72			$	0.71			$	1.28
Diluted earnings per common share					$	0.52			$	0.71			$	0.71			$	1.26
Weighted average common shares outstanding — basic						113,539				101,660				111,510				100,822
Weighted average common shares outstanding — diluted						114,552				103,440				112,291				102,900

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

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS

				For the Six Months
				Ended June 30,
				2003				2002
(in thousands, except per share amounts)
				(unaudited)
Operations:
	Net investment income			$	87,268			$	96,430
	Net realized gains				56,879				8,850
	Net change in unrealized appreciation or depreciation				(64,334	)			24,135
		Net increase in net assets resulting from operations			79,813				129,415
Shareholder distributions:
	Common stock dividends				(127,474	)			(109,482	)
	Preferred stock dividends				(110	)			(110	)
		Net decrease in net assets resulting from shareholder distributions			(127,584	)			(109,592	)
Capital share transactions:
	Sale of common stock				145,126				49,920
	Issuance of common stock upon the exercise of stock options				2,657				11,626
	Issuance of common stock in lieu of cash distributions				3,327				3,123
	Net decrease (increase) in notes receivable from sale of common stock				1,719				(2,162	)
	Other				14				—
		Net increase in net assets resulting from capital share transactions			152,843				62,507
		Total increase in net assets			105,072				82,330
Net assets at beginning of period					1,546,071				1,352,123
Net assets at end of period				$	1,651,143			$	1,434,453
Net asset value per common share				$	14.23			$	14.02
Common shares outstanding at end of period					116,034				102,296

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

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

					For the Six Months
					Ended June 30,
					2003				2002
(in thousands)
					(unaudited)
Cash flows from operating activities:
	Net increase in net assets resulting from operations				$	79,813			$	129,415
	Adjustments
		Portfolio investments				(526,399	)			(195,455	)
		Repayments of investment principal				150,277				67,017
		Proceeds from investment sales				276,708				126,280
		Change in accrued or reinvested interest and dividends				(20,405	)			(19,463	)
		Amortization of loan discounts and fees				(7,233	)			(6,478	)
		Changes in other assets and liabilities				(23,172	)			(21,788	)
		Depreciation and amortization				826				657
		Gain on cashless exercise of warrants				(3,876	)			—
		Realized losses				4,347				6,579
		Net change in unrealized appreciation or depreciation				64,334				(24,135	)
			Net cash provided by (used in) operating activities			(4,780	)			62,629
Cash flows from financing activities:
	Sale of common stock					145,126				49,920
	Sale of common stock upon the exercise of stock options					2,657				9,245
	Collections of notes receivable from sale of common stock					1,719				220
	Common dividends and distributions paid					(127,329	)			(106,359	)
	Preferred stock dividends paid					(110	)			(110	)
	Borrowings under notes payable and debentures					300,000				—
	Repayments on notes payable and debentures					(140,000	)			(6,856	)
	Net repayments on revolving line of credit					(178,750	)			(5,000	)
	Other financing activities					(2,235	)			(259	)
			Net cash provided by (used in) financing activities			1,078				(59,199	)
Net increase (decrease) in cash and cash equivalents						(3,702	)			3,430
Cash and cash equivalents at beginning of period						11,186				889
Cash and cash equivalents at end of period					$	7,484			$	4,319

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

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF INVESTMENTS

					June 30, 2003
Private Finance
Portfolio Company					(unaudited)
(in thousands, except number of shares)			Investment(2)		Cost				Value
Companies More Than 25% Owned
Acme Paging, L.P.			Loan		$	4,265			$	4,265
	(Telecommunications)		Equity Interests			13,274				6,525
			Common Stock (940 shares)			27				—
Alaris Consulting, LLC			Loan			18,635				17,300
	(Business Services)		Equity Interests			5,165				—
			Guaranty ($1,100)
American Healthcare Services, Inc.			Loan			24,851				24,851
	(Healthcare)		Debt Securities			17,311				11,388
			Common Stock (7,956,704 shares)			1,000				—
			Guaranty ($1,590)
Avborne, Inc.			Loan			2,770				2,770
	(Business Services)		Preferred Stock (12,500 shares)			14,138				2,300
			Common Stock (27,500 shares)			—				—
			Standby Letter of Credit ($7,006)
Business Loan Express, LLC			Loans			20,000				20,000
	(Financial Services)		Debt Securities			39,267				39,267
			Class A Equity Interests			45,044				45,044
			Class B Equity Interests			52,111				95,986
			Class C Equity Interests			108,241				156,461
			Guaranty ($53,591 — See Note 3)
			Standby Letters of Credit ($25,550 — See Note 3)
The Color Factory, Inc.			Loan			13,389				9,854
	(Consumer Products)		Preferred Stock (1,000 shares)			1,002				—
			Common Stock (980,000 shares)			6,535				—
Foresite Towers, LLC			Equity Interests			15,522				14,170
	(Tower Leasing)
Gordian Group, Inc.			Loan			8,935				8,935
	(Business Services)		Common Stock (1,000 shares)			2,385				3,500
HealthASPex, Inc.			Preferred Stock (1,000,000 shares)			700				700
	(Business Services)		Preferred Stock (1,451,380 shares)			4,900				2,601
			Common Stock (1,451,380 shares)			4				—
The Hillman Companies, Inc.(1)			Debt Securities			42,953				42,953
	(Consumer Products)		Common Stock (6,890,937 shares)			50,645				138,863
HMT, Inc.			Debt Securities			9,129				9,129
	(Business Services)		Preferred Stock (554,052 shares)			2,303				2,303
			Common Stock (300,000 shares)			3,000				3,000
			Warrants			1,155				1,155

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

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					June 30, 2003
Private Finance
Portfolio Company					(unaudited)
(in thousands, except number of shares)			Investment(2)		Cost				Value
Housecall Medical Resources, Inc.			Loan		$	15,062			$	15,062
	(Healthcare)		Preferred Stock (3,890,344 shares)			3,889				3,889
			Common Stock (864,000 shares)			86				3,687
Jakel, Inc.			Loan			500				500
	(Industrial Products)		Debt Securities			7,500				7,500
			Preferred Stock (6,460 shares)			6,460				3,467
			Common Stock (158,061 shares)			9,347				—
			Standby Letter of Credit ($4,500)
Litterer Beteiligungs-GmbH(3)			Debt Securities			1,404				1,032
	(Business Services)		Equity Interest			295				—
MVL Group, Inc.			Loan			18,765				18,570
	(Business Services)		Debt Securities			16,525				15,132
			Common Stock (648,661 shares)			810				—
Powell Plant Farms, Inc.			Loan			18,697				18,697
	(Consumer Products)		Debt Securities			19,224				9,709
			Preferred Stock (1,483 shares)			—				—
			Warrants			—				—
Redox Brands, Inc.			Loan			3,031				3,031
	(Consumer Products)		Debt Securities			10,039				10,039
			Preferred Stock (2,404,086 shares)			6,965				6,965
			Warrants			584				584
			Guaranty ($125)
Staffing Partners Holding			Debt Securities			6,304				6,304
	Company, Inc.		Preferred Stock (414,600 shares)			4,968				4,074
	(Business Services)		Common Stock (50,200 shares)			50				—
			Warrants			10				—
STS Operating, Inc.			Preferred Stock (5,769,424 shares)			6,525				6,525
	(Industrial Products)		Common Stock (3,000,000 shares)			3,177				3,177
Sure-Tel, Inc.			Preferred Stock (1,000,000 shares)			1,000				1,000
	(Consumer Services)		Common Stock (37,000 shares)			5,018				1,530
Total companies more than 25% owned					$	694,891			$	803,794
Companies 5% to 25% Owned
Allied Office Products, Inc.			Common Stock (31,333 shares)		$	7,695			$	50
	(Business Services)
Aspen Pet Products, Inc.			Loans			17,145				17,145
	(Consumer Products)		Preferred Stock (2,112 shares)			2,024				1,348
			Common Stock (1,400 shares)			140				—
			Warrants			—				—
Autania AG(1,3)			Common Stock (250,000 shares)			2,169				2,900
	(Industrial Products)

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

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					June 30, 2003
Private Finance
Portfolio Company					(unaudited)
(in thousands, except number of shares)			Investment(2)		Cost				Value
Blue Rhino Corporation(1)			Debt Securities		$	5,094			$	5,094
	(Consumer Products)		Common Stock (1,070,179 shares)			5,076				12,842
Border Foods, Inc.			Debt Securities			9,421				9,421
	(Consumer Products)		Preferred Stock (50,919 shares)			2,000				2,000
			Common Stock (1,810 shares)			45				45
			Warrants			665				665
CBA-Mezzanine Capital Finance, LLC			Loan			8,337				8,337
	(Financial Services)
CorrFlex Graphics, LLC			Debt Securities			12,318				12,318
	(Business Services)		Warrants			—				19,332
			Options			—				1,669
The Debt Exchange Inc.			Preferred Stock (921,875 shares)			1,250				1,250
	(Business Services)
EDM Consulting, LLC			Debt Securities			1,802				236
	(Business Services)		Equity Interests			250				—
International Fiber Corporation			Debt Securities			22,715				22,715
	(Industrial Products)		Common Stock (1,029,069 shares)			5,483				6,816
			Warrants			550				684
Liberty-Pittsburgh Systems, Inc.			Debt Securities			3,384				3,384
	(Business Services)		Common Stock (123,929 shares)			142				—
Logic Bay Corporation			Common Stock (1,437,420 shares)			5,000				—
	(Business Services)
Magna Card, Inc.			Debt Securities			154				154
	(Consumer Products)		Preferred Stock (1,875 shares)			94				28
			Common Stock (4,687 shares)			—				—
Master Plan, Inc.			Loan			959				959
	(Business Services)		Common Stock (156 shares)			42				—
MortgageRamp, Inc.			Common Stock (772,000 shares)			3,860				2,084
	(Business Services)
Nobel Learning Communities,			Debt Securities			9,809				9,809
	Inc.(1)		Preferred Stock (1,063,830 shares)			2,000				2,000
	(Education)		Warrants			575				191
Packaging Advantage Corporation			Debt Securities			14,290				14,290
	(Business Services)		Common Stock (232,168 shares)			2,386				2,386
			Warrants			963				963
Professional Paint, Inc.			Debt Securities			23,507				23,507
	(Consumer Products)		Preferred Stock (15,000 shares)			20,803				20,803
			Common Stock (110,000 shares)			69				5,995

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-42

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						June 30, 2003
Private Finance
Portfolio Company						(unaudited)
(in thousands, except number of shares)				Investment(2)		Cost				Value
Progressive International				Debt Securities		$	3,973			$	3,973
	Corporation			Preferred Stock (500 shares)			500				500
	(Consumer Products)			Common Stock (197 shares)			13				150
				Warrants			—				—
Sidarus Holdings, Inc.				Debt Securities			4,976				4,976
	(Business Services)			Preferred Stock (98,000 shares)			980				980
				Common Stock (492,941 shares)			20				20
				Warrants			—				—
Total Foam, Inc.				Debt Securities			254				124
	(Industrial Products)			Common Stock (164 shares)			10				—
Total companies 5% to 25% owned						$	202,942			$	222,143
Companies Less Than 5% Owned
ACE Products, Inc.				Loan		$	17,164			$	50
	(Industrial Products)
Advantage Sales and Marketing,				Debt Securities			10,625				10,625
	Inc.			Warrants			382				1,556
	(Business Services)
Alderwoods Group, Inc.(1)				Common Stock (357,568 shares)			5,006				1,913
	(Consumer Services)
American Barbecue & Grill, Inc.				Warrants			125				—
	(Retail)
ASW Holding Corporation				Warrants			25				—
	(Industrial Products)
Aviation Technologies, Inc.				Loan			19,901				19,901
	(Industrial Products)
Bakery Chef, Inc.				Loans			18,838				18,838
	(Consumer Products)
Benchmark Medical, Inc.				Debt Securities			13,414				13,414
	(Healthcare)			Warrants			18				18
Camden Partners Strategic Fund II, L.P.(4)				Limited Partnership Interest			3,247				3,095
	(Private Equity Fund)
Candlewood Hotel Company(1)				Preferred Stock (3,250 shares)			3,250				635
	(Hospitality)
Clif Bar, Inc.				Loan			24,906				24,906
	(Consumer Products)
Colibri Holding Corporation				Debt Securities			3,495				3,495
	(Consumer Products)			Preferred Stock (237 shares)			300				300
				Common Stock (3,362 shares)			1,250				1,088
				Warrants			290				252

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-43

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					June 30, 2003
Private Finance
Portfolio Company					(unaudited)
(in thousands, except number of shares)			Investment(2)		Cost				Value
Component Hardware Group, Inc.			Debt Securities		$	11,544			$	11,544
	(Industrial Products)		Preferred Stock (18,000 shares)			2,312				2,312
			Common Stock (2,000 shares)			200				700
Cooper Natural Resources, Inc.			Loan			299				299
	(Industrial Products)		Debt Securities			1,955				1,955
			Preferred Stock (6,316 shares)			1,427				1,427
			Warrants			832				832
Coverall North America, Inc.			Loan			12,410				12,410
	(Business Services)		Debt Securities			6,426				6,426
CTT Holdings			Loan			1,250				1,250
	(Consumer Products)
Drilltec Patents & Technologies			Loan			10,918				—
	Company, Inc.		Debt Securities			1,500				—
	(Industrial Products)
eCentury Capital Partners, L.P.(4)			Limited Partnership Interest			3,125				735
	(Private Equity Fund)
Elexis Beta GmbH(3)			Options			426				289
	(Industrial Products)
Eparfin S.A.(3)			Loan			29				29
	(Consumer Products)
E-Talk Corporation			Debt Securities			8,852				—
	(Business Services)		Warrants			1,157				—
Executive Greetings, Inc.			Debt Securities			18,830				50
	(Business Services)		Warrants			360				—
Fairchild Industrial Products			Debt Securities			5,954				5,426
	Company		Warrants			280				—
	(Industrial Products)
Frozen Specialties, Inc.			Debt Securities			10,050				10,050
	(Consumer Products)		Warrants			435				435
Galaxy American			Debt Securities			49,704				12,712
	Communications, LLC		Options			—				—
	(Broadcasting & Cable)		Standby Letter of Credit ($37)
Garden Ridge Corporation			Debt Securities			27,271				25,000
	(Retail)		Preferred Stock (1,130 shares)			1,130				—
			Common Stock (847,800 shares)			613				—
Gibson Guitar Corporation			Debt Securities			18,354				18,354
	(Consumer Products)		Warrants			525				2,325
Ginsey Industries, Inc.			Loans			5,000				5,000
	(Consumer Products)		Convertible Debentures			500				500
			Warrants			—				2,250

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-44

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					June 30, 2003
Private Finance
Portfolio Company					(unaudited)
(in thousands, except number of shares)			Investment(2)		Cost				Value
Global Communications, LLC			Loan		$	2,348			$	2,348
	(Business Services)		Debt Securities			16,711				16,711
			Preferred Equity Interest			14,067				14,193
			Options			1,639				3,551
Grant Broadcasting Systems II			Warrants			87				3,000
	(Broadcasting & Cable)
Grotech Partners, VI, L.P.(4)			Limited Partnership Interest			3,520				2,591
	(Private Equity Fund)
The Hartz Mountain Corporation			Debt Securities			27,845				27,845
	(Consumer Products)		Common Stock (200,000 shares)			2,000				1,821
			Warrants			2,613				2,379
Haven Eldercare of New England, LLC			Loan			35,903				35,903
	(Healthcare)
Headwaters Incorporated(1)			Loan			9,958				9,958
	(Industrial Products)
Healthmarket, Inc.			Debt Securities			9,583				9,583
	(Health Insurance)		Warrants			440				440
Hotelevision, Inc.			Common Stock (315,100 shares)			315				—
	(Broadcasting & Cable)
Icon International, Inc.			Common Stock (25,707 shares)			1,219				1,740
	(Business Services)
Impact Innovations Group, LLC			Debt Securities			6,797				3,541
	(Business Services)		Warrants			1,674				—
Insight Pharmaceuticals Corporation			Loan			9,952				9,952
	(Consumer Products)
Intellirisk Management Corporation			Loan			23,757				23,757
	(Business Services)
Interline Brands, Inc.			Preferred Stock (199,313 shares)			1,849				1,849
	(Business Services)		Common Stock (15,615 shares)			139				—
			Warrants			1,181				—
JRI Industries, Inc.			Debt Securities			1,548				1,548
	(Industrial Products)		Warrants			74				39
Julius Koch USA, Inc.			Warrants			259				4,750
	(Industrial Products)
Kirker Enterprises, Inc.			Equity Interest			4				4
	(Industrial Products)		Warrants			348				3,501
Kyrus Corporation			Debt Securities			6,431				6,431
	(Business Services)		Warrants			348				450

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-45

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					June 30, 2003
Private Finance
Portfolio Company					(unaudited)
(in thousands, except number of shares)			Investment(2)		Cost				Value
Love Funding Corporation			Preferred Stock (26,000 shares)		$	359			$	359
	(Financial Services)
Matrics, Inc.			Preferred Stock (511,876 shares)			500				938
	(Business Services)		Warrants			—				—
MedAssets, Inc.			Debt Securities			16,412				16,412
	(Business Services)		Preferred Stock (229,806 shares)			2,049				2,049
			Warrants			136				136
Mid-Atlantic Venture Fund IV, L.P.(4)			Limited Partnership Interest			4,725				2,674
	(Private Equity Fund)
Midview Associates, L.P.			Warrants			—				—
	(Housing)
Mogas Energy, LLC			Debt Securities			18,226				18,226
	(Natural Gas Pipelines)		Warrants			1,774				1,774
Norstan Apparel Shops, Inc.			Debt Securities			11,850				11,850
	(Retail)		Common Stock (29,622 shares)			4,750				4,750
			Warrants			655				655
Northeast Broadcasting Group, L.P.			Debt Securities			235				235
	(Broadcasting & Cable)
Novak Biddle Venture Partners III, L.P.(4)			Limited Partnership Interest			870				694
	(Private Equity Fund)
Nursefinders, Inc.			Debt Securities			11,262				11,262
	(Business Services)		Warrants			900				900
Oahu Waste Services, Inc.			Debt Securities			8,178				8,178
	(Business Services)		Stock Appreciation Rights			239				239
Onyx Television GmbH (3)			Preferred Units			201				—
	(Broadcasting & Cable)
Opinion Research Corporation(1)			Debt Securities			14,401				14,401
	(Business Services)		Warrants			996				996
Oriental Trading Company, Inc.			Preferred Equity Interest			1,751				1,751
	(Consumer Products)		Common Equity Interest			—				3,500
Pico Products, Inc.			Loan			1,406				1,406
	(Industrial Products)
Polaris Pool Systems, Inc.			Debt Securities			10,880				10,880
	(Consumer Products)		Warrants			1,145				1,145
Prosperco Finanz Holding AG(3)			Convertible Debentures			7,738				5,000
	(Financial Services)		Common Stock (1,528 shares)			1,059				—
			Warrants			—				—

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-46

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					June 30, 2003
Private Finance
Portfolio Company					(unaudited)
(in thousands, except number of shares)			Investment(2)		Cost				Value
Resun Leasing, Inc.			Loan		$	30,000			$	30,000
	(Business Services)
Scitor Corporation			Loan			22,511				22,511
	(Business Services)
Simula, Inc.(1)			Loan			21,853				21,853
	(Industrial Products)
SmartMail, LLC			Loan			3,731				3,731
	(Business Services)		Debt Securities			4,400				4,400
			Equity Interests			1,070				1,070
			Warrants			3				3
Soff-Cut Holdings, Inc.			Debt Securities			9,599				9,599
	(Industrial Products)		Preferred Stock (300 shares)			300				300
			Common Stock (2,000 shares)			200				—
Southwest PCS, LLC			Loan			500				500
	(Telecommunications)
Spa Lending Corporation			Preferred Stock (28,672 shares)			424				306
	(Recreation)
Startec Global Communications			Loan			25,715				25,715
	Corporation(1)		Debt Securities			20,670				—
	(Telecommunications)
SunStates Refrigerated Services,			Loans			4,566				1,424
	Inc.		Debt Securities			2,445				—
	(Warehouse Facilities)
Sydran Food Services II, L.P.			Debt Securities			12,973				6,646
	(Retail)		Equity Interests			3,747				—
			Warrants			162				—
Tubbs Snowshoe Company, LLC			Debt Securities			4,036				4,036
	(Consumer Products)		Equity Interests			500				500
			Warrants			54				20
United Pet Group, Inc.			Debt Securities			9,125				9,125
	(Consumer Products)		Warrants			85				350
United Site Services, Inc.			Loan			14,925				14,925
	(Business Services)
Updata Venture Partners II, L.P.(4)			Limited Partnership Interest			1,705				2,036
	(Private Equity Fund)
U.S. Security Holdings, Inc.			Debt Securities			24,164				24,164
	(Business Services)		Warrants			826				1,200
Venturehouse-Cibernet Investors, LLC			Equity Interest			34				34
	(Business Services)

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-47

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						June 30, 2003
Private Finance
Portfolio Company						(unaudited)
(in thousands, except number of shares)				Investment(2)		Cost				Value
Venturehouse Group, LLC(4)				Equity Interest		$	1,000			$	236
	(Private Equity Fund)
Vertex Aerospace, LLC				Debt Securities			5,290				5,290
	(Business Services)			Equity Interest			—				400
VICORP Restaurants, Inc.				Debt Securities			23,849				23,849
	(Retail)			Warrants			33				33
Walker Investment Fund II, LLLP(4)				Limited Partnership Interest			1,246				518
	(Private Equity Fund)
Warn Industries, Inc.				Debt Securities			4,439				4,439
	(Consumer Products)			Warrants			1,429				5,352
Weston Solutions, Inc.				Loan			12,189				12,189
	(Business Services)
Wilshire Restaurant Group, Inc.				Debt Securities			16,691				16,691
	(Retail)			Warrants			735				855
Wilton Industries, Inc.				Loan			9,600				9,600
	(Consumer Products)
Woodstream Corporation				Debt Securities			16,329				16,329
	(Consumer Products)			Common Stock (180 shares)			1,800				1,800
				Warrants			587				587
Total companies less than 5% owned						$	946,750			$	813,307
Total private finance (128 portfolio companies)						$	1,844,583			$	1,839,244

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-48

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												June 30, 2003
				Stated								(unaudited)
(in Thousands)				Interest				Face				Cost				Value
Commercial Real Estate Finance
Commercial Mortgage-Backed Securities
	Mortgage Capital Funding, Series 1998-MC3				5.5	%		$	47,103			$	25,867			$	25,543
	Morgan Stanley Capital I, Series 1999-RM1				6.4	%			29,629				9,685				9,999
	COMM 1999-1				5.7	%			57,163				26,336				27,489
	Morgan Stanley Capital I, Series 1999-FNV1				6.1	%			28,595				14,150				12,985
	DLJ Commercial Mortgage Trust 1999-CG2				6.1	%			44,635				13,913				14,446
	Commercial Mortgage Acceptance Corp., Series 1999-C1				6.8	%			18,346				5,146				5,911
	LB Commercial Mortgage Trust, Series 1999-C2				6.7	%			11,603				1,771				1,743
	Chase Commercial Mortgage Securities Corp., Series 1999-2				6.5	%			20,545				5,481				6,148
	FUNB CMT, Series 1999-C4				6.5	%			22,887				7,868				7,709
	Heller Financial, HFCMC Series 2000 PH-1				6.6	%			25,767				8,803				9,110
	SBMS VII, Inc., Series 2000-NL1				7.2	%			9,214				4,572				4,551
	DLJ Commercial Mortgage Trust, Series 2000-CF1				7.0	%			24,328				9,459				9,834
	Deutsche Bank Alex. Brown, Series Comm 2000-C1				6.9	%			17,922				5,127				3,975
	LB-UBS Commercial Mortgage Trust, Series 2000-C4				6.9	%			17,484				3,971				4,562
	Credit Suisse First Boston Mortgage Securities Corp., Series 2001-CK1				5.9	%			21,805				8,497				8,536
	JP Morgan-CIBC-Deutsche 2001				5.8	%			25,370				6,855				6,815
	Lehman Brothers-UBS Warburg 2001-C2				6.4	%			22,756				6,598				6,649
	SBMS VII, Inc., Series 2001-C1				6.1	%			23,049				5,648				4,988
	GE Capital Commercial Mortgage Securities Corp., Series 2001-2				6.1	%			21,228				6,355				5,985
	Credit Suisse First Boston Mortgage Securities Corp., Series 2001-CKN5				5.2	%			21,456				5,209				5,343
	JP Morgan Chase Commercial Mortgage Securities Corp., Series 2001-C1				5.6	%			24,493				5,855				5,575
	SBMS VII, Inc., Series 2001-C2				6.2	%			21,619				5,887				5,711
	FUNB CMT, Series 2002-C1				6.0	%			28,303				11,624				12,099
	GE Capital Commercial Mortgage Corp., Series 2002-1				6.2	%			50,631				24,998				30,182
	GMAC Commercial Mortgage Securities, Inc., Series 2002-C2				5.8	%			40,573				20,125				22,889
	GE Capital Commercial Mortgage Corp., Series 2002-3				5.1	%			50,047				22,604				24,218
	Morgan Stanley Dean Witter Capital I Trust 2002-IQ3				6.0	%			27,858				13,163				14,097
	LB-UBS Commercial Mortgage Trust 2003-C1				4.6	%			50,896				22,122				23,349
	GS Mortgage Securities Corporation II Series 2003-C1				4.7	%			39,543				19,148				19,570
	J.P. Morgan Chase Commercial Mortgage Securities Corp., Series 2003-ML1				4.9	%			15,946				12,315				12,738
	Credit Suisse First Boston Mortgage Securities Corp., Series 2003-CK2				4.9	%			69,680				37,674				39,150
	GE Commercial Mortgage Corporation 2003-C1				5.1	%			20,389				16,006				16,873
	COMM 2003-LNB1				4.4	%			36,803				14,668				14,865
		Total commercial mortgage-backed securities						$	987,666			$	407,500			$	423,637

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-49

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				June 30, 2003
				(unaudited)
(in Thousands)				Cost				Value
Collateralized Debt Obligations
	Crest 2001-1, Ltd.(3)			$	23,126			$	23,126
	Crest 2002-1, Ltd.(3)				23,811				23,811
	Crest 2002-IG, Ltd.(3)				4,731				4,731
	Crest Clarendon Street 2002-1, Ltd.(3)				1,023				1,023
	Crest 2003-1, Ltd.(3)				114,139				114,684
		Total collateralized debt obligations		$	166,830			$	167,375

			Interest				Number of
			Rate Ranges				Loans				Cost				Value
Commercial Mortgage Loans
				Up to 6.99%				11			$	10,655			$	11,485
				7.00%–8.99%				17				37,178				34,541
				9.00%–10.99%				9				43,972				43,901
				11.00%–12.99%				13				18,211				11,301
				13.00%–14.99%				4				4,824				3,275
			15.00% and above					1				876				876
	Total commercial mortgage loans							55			$	115,716			$	105,379
Real Estate Owned												12,841				10,505
	Total commercial real estate finance											702,887				706,896
Total portfolio											$	2,547,470			$	2,546,140

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options, and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

S-50

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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 invests 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 2002 balances to conform with the 2003 financial statement presentation.

      The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, the unaudited consolidated financial results of the Company included herein contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position of the Company as of June 30, 2003, and the results of operations for the three and six months ended June 30, 2003 and 2002, and changes in net assets and cash flows for the six months ended June 30, 2003 and 2002. The results of operations for the three and six months ended June 30, 2003, are not necessarily indicative of the operating results to be expected for the full year.

      The private finance portfolio, the interest and related portfolio income and net realized gains (losses) earned 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

S-51

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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 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.

	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 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 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 are 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 or 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

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contractual interest accrued and added to the loan balance that 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 classified as Grade 4 or 5 assets 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 if such companies are in need of additional working capital. Loan origination fees, original issue discount, and market discount are capitalized and then amortized into interest income using the effective interest method. Prepayment premiums are recorded on loans when received.

      The weighted average yield on loans and debt securities is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount, and market discount earned on accruing loans and debt securities, 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 or other liquidation events. The determined fair 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 upon 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 market yields for similar CMBS bonds and CDO bonds and preferred shares. 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 estimates of future credit losses, actual losses incurred, or actual and estimated prepayment speeds. 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. The Company recognizes unrealized appreciation or depreciation on its CMBS bonds and CDO bonds and preferred shares as comparable yields in the

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

market change and based on changes in estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool.

	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.

	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 investment 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 investment advisory services fees are generally recognized as income as the services are rendered.

	Deferred Financing Costs

      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.

	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.

	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. However, certain guarantees are excluded from the initial recognition provisions of the Interpretation. See Note 5 for disclosures related to the Company’s guarantees.

	Dividends to Shareholders

      Dividends to shareholders are recorded on the record date.

	Stock Compensation Plans

      At June 30, 2003 and 2002, the Company had a stock-based employee compensation plan. 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

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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 Six
			Months Ended
			June 30,
			2003				2002
(in thousands, except per share amounts)
Net increase in net assets resulting from operations as reported			$	79,813			$	129,415
Less total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects				(8,078	)			(3,632	)
Pro forma net increase in net assets resulting from operations				71,735				125,783
Less preferred stock dividends				(110	)			(110	)
Pro forma income available to common shareholders			$	71,625			$	125,673
Basic earnings per common share:
	As reported		$	0.71			$	1.28
	Pro forma		$	0.64			$	1.25
Diluted earnings per common share:
	As reported		$	0.71			$	1.26
	Pro forma		$	0.64			$	1.22

      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, with the following weighted average assumptions for options granted during the six months ended June 30, 2003 and 2002:

		For the Six
		Months Ended
		June 30,
		2003				2002
Risk-free interest rate			2.6	%			4.5	%
Expected life			5.0				5.0
Expected volatility			38.8	%			39.7	%
Dividend yield			8.9	%			8.5	%
Weighted average fair value per option		$	3.31			$	4.82

	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 annually distribute or retain through a deemed distribution all of their taxable income to shareholders; therefore, the Company has made no provision for 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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	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 accounting principles generally accepted in the United States of America 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 $2.5 billion as of June 30, 2003, and December 31, 2002. At June 30, 2003, and December 31, 2002, 89% and 88%, respectively, of our total assets represented 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.

	New Accounting Pronouncements

      In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity which provides guidance on how an entity classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The statement requires cumulative effect transition for financial instruments existing at adoption date. The Company does not expect the adoption of this statement to have a significant effect on the Company’s financial position or its results of operations.

Note 3. Portfolio

  Private Finance

      At June 30, 2003, and December 31, 2002, the private finance portfolio consisted of the following:

			2003												2002
			Cost				Value				Yield				Cost				Value				Yield
($ in thousands)
Loans and debt securities			$	1,351,947			$	1,192,452				14.4	% (1)		$	1,272,401			$	1,151,256				14.4	% (1)
Equity interests				492,636				646,792								438,501				591,959
	Total		$	1,844,583			$	1,839,244							$	1,710,902			$	1,743,215

(1)

The weighted average yield on loans and debt securities is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount, and market discount earned on accruing loans and debt securities, divided by (b) total loans and debt securities at value. At June 30, 2003, the cost and value of loans and debt securities include the Class A equity interests in BLX and the yield includes dividends earned on these equity interests. The weighted average yield is computed as of the balance sheet date.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     Private finance investment activity principally involves providing financing through privately negotiated long-term debt and equity investments. 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. Private finance investments are generally issued by privately owned companies and are generally illiquid and subject to restrictions on resale or transferability.

      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. At June 30, 2003, and December 31, 2002, approximately 96% and 95%, respectively, of the Company’s loans and debt securities had fixed interest rates.

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

      The Company may acquire more than 50% of the common stock of a portfolio company in a control buyout transaction. The Company’s most significant investments acquired through control buyout transactions both at June 30, 2003, and December 31, 2002, were Business Loan Express, LLC and The Hillman Companies, Inc.

      At June 30, 2003, and December 31, 2002, the Company had an investment at value totaling $356.8 million and $256.8 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. During the first quarter of 2003, the Company invested $50 million in BLX in the form of a $25 million short-term line of credit and $25 million of preferred equity in connection with BLX’s acquisition of $128 million in assets from Amresco Independence Funding, Inc. BLX also completed its corporate reorganization to a limited liability company during the first quarter 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 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. At June 30, 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.

      At the time of the corporate reorganization of BLX, Inc. from a C corporation to a limited liability company, 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 regulated investment company, the Company will be subject to the 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

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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 its future tax liability resulting from the built-in gains at the date of BLX’s reorganization may total up to $42 million. At June 30, 2003, the Company has 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 corresponding 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 up to 50% of the total obligations (consisting of principal, accrued interest, and other fees) on BLX’s three-year unsecured $164.0 million revolving credit facility that matures in March 2004. The amount guaranteed by the Company at June 30, 2003, was $53.6 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 June 30, 2003. The Company has also provided three standby letters of credit in connection with three term securitization transactions completed by BLX totaling $25.6 million. In consideration for providing this guaranty and the three standby letters of credit, BLX paid the Company fees of $1.9 million and $1.6 million for the six months ended June 30, 2003 and 2002, respectively. BLX is headquartered in New York, NY.

      At June 30, 2003, and December 31, 2002, the Company had an investment in The Hillman Companies, Inc. (“Hillman”) totaling $181.8 million and $180.5 million at value, respectively. At June 30, 2003, the Company owned 96.8% of Hillman’s common stock. The Company’s common stock ownership is subject to dilution by management options. Hillman is a leading manufacturer of key making equipment and distributor of key blanks, fasteners, signage, and other small hardware components and operates in multiple channels of the retail marketplace such as hardware stores, national and regional home centers, and mass merchants. Hillman has certain patent-protected products including key duplication technology that is important to its business. Hillman’s primary operations are located in Cincinnati, Ohio.

      Total interest and portfolio related income earned from the Company’s investments in BLX and Hillman for the six months ended June 30, 2003 and 2002, was $27.5 million and $24.5 million, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      At June 30, 2003, and December 31, 2002, loans and debt securities in workout status (classified as Grades 4 and 5 under the Company’s internal grading system) that were not accruing interest were as follows at value:

			2003				2002
(in thousands)
Companies more than 25% owned			$	23,828			$	9,709
Companies 5% to 25% owned				360				411
Companies less than 5% owned				33,801				65,931
	Total		$	57,989			$	76,051

      In addition to Grade 4 and 5 assets that are in workout, the Company may not accrue interest on loans and debt securities to companies that are more than 50% owned by the Company if such companies are in need of additional working capital and, therefore, the Company may defer current debt service. Loans and debt securities to such companies totaled $72.2 million and $63.6 million at value at June 30, 2003, and December 31, 2002, respectively. In addition, loans to companies that are less than 50% owned by the Company and were not in workout but were not accruing interest totaled $1.0 million and $7.2 million at value at June 30, 2003, and December 31, 2002, respectively.

      The industry and geographic compositions of the private finance portfolio at value at June 30, 2003, and December 31, 2002, were as follows:

			2003				2002
Industry
Consumer products				30	%			34	%
Business services				24				26
Financial services				20				16
Industrial products				8				9
Healthcare				6				5
Retail				5				4
Telecommunications				2				2
Education				1				1
Broadcasting & cable				1				1
Other				3				2
	Total			100	%			100	%

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

			2003				2002
Geographic Region
Mid-Atlantic				51	%			45	%
West				17				15
Southeast				14				16
Midwest				11				16
Northeast				6				7
International				1				1
	Total			100	%			100	%

  Commercial Real Estate Finance

      At June 30, 2003, and December 31, 2002, the commercial real estate finance portfolio consisted of the following:

			2003												2002
			Cost				Value				Yield(1)				Cost				Value				Yield(1)
($ in thousands)
CMBS bonds			$	407,500			$	423,637				13.9	%		$	523,671			$	555,519				14.2	%
Collateralized debt obligation bonds and preferred shares				166,830				167,375				16.6	%			52,818				52,818				17.2	%
Loans				115,716				105,379				7.8	%			66,546				63,707				7.5	%
Residual interest				—				—								69,335				69,035				9.4	%
Real estate owned				12,841				10,505								5,942				3,873
	Total		$	702,887			$	706,896							$	718,312			$	744,952

(1)

The weighted average yield on the interest-bearing investments is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount, and market discount earned on accruing interest- bearing investments, 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.

     CMBS Bonds. At June 30, 2003, and December 31, 2002, CMBS bonds consisted of the following:

		2003				2002
($ in thousands)
Face		$	987,666			$	1,173,194
Original issue discount			(580,166	)			(649,523	)
Cost		$	407,500			$	523,671
Value		$	423,637			$	555,519

      The non-investment grade and unrated tranches of 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 generally is allocated first to the senior tranches, with the most senior tranches having a priority right to the cash flow. Then, any

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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 June 30, 2003, the Company’s CMBS bonds were subordinate to 91% to 99% of the tranches of bonds issued in various CMBS transactions. Given that the non-investment grade CMBS bonds in which the Company invests are junior in priority for payment of principal and interest, the Company invests in these CMBS bonds at a significant discount from the face amount of the bonds.

      The underlying rating classes of the CMBS bonds at value at June 30, 2003, and December 31, 2002, were as follows:

			2003								2002
							Percentage								Percentage
			Value				of Total				Value				of Total
($ in thousands)
BB+			$	68,699				16.2	%		$	49,811				9.0	%
BB				51,011				12.0				39,011				7.0
BB-				28,015				6.6				22,030				4.0
B+				35,915				8.5				121,038				21.8
B				31,476				7.4				141,998				25.6
B-				79,245				18.7				83,493				15.0
CCC+				12,778				3.0				—				—
CCC				18,398				4.4				8,634				1.5
Unrated				98,100				23.2				89,504				16.1
	Total		$	423,637				100.0	%		$	555,519				100.0	%

      At June 30, 2003, and December 31, 2002, the underlying collateral for the Company’s CMBS bonds consisted of approximately 5,100 and 4,500 commercial mortgage loans and real estate properties owned with a total outstanding principal balance of $32.0 billion and $25.0 billion, respectively. At June 30, 2003, and December 31, 2002, 1.2% and 1.0%, respectively, of the mortgage loans in the underlying collateral pool for the Company’s CMBS bonds were over 30 days delinquent or were classified as real estate owned.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The property types and the geographic composition of the underlying mortgage loans and real estate properties owned in the underlying collateral pool calculated using the outstanding principal balance at June 30, 2003, and December 31, 2002, were as follows:

			2003				2002
Property Type
Retail				34	%			32	%
Housing				25				27
Office				23				21
Industrial Real Estate				6				7
Hospitality				5				6
Other				7				7
	Total			100	%			100	%
Geographic Region
West				31	%			31	%
Mid-Atlantic				27				25
Midwest				22				22
Southeast				16				17
Northeast				4				5
	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 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, rental rates and tenant credit quality) and changes in market rental rates. The initial yield on each CMBS bond has been computed assuming an approximate 1% loss rate on its entire 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 amount of losses and the expected timing of recognition of such losses will be updated, and the respective yield will be adjusted as necessary. 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.

  Collateralized Debt Obligation Bonds and Preferred Shares (“CDOs”). At June 30, 2003, the Company owned BBB rated bonds in one CDO totaling $24.3 million at value and preferred shares in five CDOs totaling $143.1 million at value secured by investment grade unsecured debt issued by various real estate investment trusts (“REITs”) and investment and non-investment grade CMBS bonds. The investment grade REIT collateral consists of debt with a cut-off balance of $1.2 billion and was issued by 39 REITs. The investment grade CMBS collateral consists of CMBS bonds with a face amount of $496.0 million issued in 41 separate CMBS transactions and the non-investment grade CMBS collateral consists of BB+, BB, BB–, B+, and B rated CMBS bonds with a face amount of $873.7 million issued in 42 separate CMBS transactions (“CMBS Collateral”). Included in the CMBS Collateral for the CDOs are $793.7 million of CMBS bonds that are senior in priority of repayment to certain lower rated CMBS bonds held by the Company, which were issued in 27 separate CMBS transactions.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The BBB rated bonds and the preferred shares owned by the Company are junior in priority for payment of principal and interest to the more senior tranches of debt issued by the CDOs. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, the preferred shares will bear this loss first and then the BBB rated bonds would bear any loss after the preferred shares. At June 30, 2003, the Company’s BBB bonds and preferred shares in the CDOs were subordinate to 61% to 98% of the more senior tranches of debt issued in various CDO transactions.

      As of June 30, 2003, the Company acted as the disposition consultant with respect to four of the CDOs, which allows the Company to approve disposition plans for individual collateral securities. As of June 30, 2002, the Company acted as the disposition consultant with respect to two of the CDOs. For these services, the Company collects annual fees based on the outstanding collateral pool balance, and for the six months ended June 30, 2003 and 2002, these fees totaled $515 thousand and $160 thousand, respectively.

      Loans. The commercial mortgage loan portfolio contains loans that were originated by the Company or were purchased from third-party sellers. At June 30, 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, 2002, approximately 84% and 16% of the Company’s commercial mortgage loan portfolio was composed of fixed and adjustable interest rate loans, respectively. As of June 30, 2003, and December 31, 2002, loans with a value of $19.9 million and $13.0 million, respectively, were not accruing interest. Loans greater than 120 days delinquent generally do not accrue interest.

      The property types and the geographic composition securing the commercial mortgage loan portfolio at value at June 30, 2003, and December 31, 2002, were as follows:

			2003				2002
Property Type
Hospitality				31	%			23	%
Office				29				20
Retail				22				21
Healthcare				8				15
Recreation				2				3
Other				8				18
	Total			100	%			100	%
Geographic Region
Southeast				34	%			40	%
Midwest				24				12
West				19				20
Mid-Atlantic				17				17
Northeast				6				11
	Total			100	%			100	%

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

  Residual Interest. At June 30, 2003, and December 31, 2002, the residual interest consisted of the following:

			2003								2002
			Cost				Value				Cost				Value
(in thousands)
Residual interest			$	—			$	—			$	68,853			$	68,853
Residual interest spread				—				—				482				182
	Total		$	—			$	—			$	69,335			$	69,035

      The residual interest primarily consisted of a retained interest from a 1998 asset securitization. At March 31, 2003, one class of bonds rated AAA was outstanding, totaling $6.0 million. During April 2003, the call provision was exercised and, accordingly, the bondholders were repaid in full and the remaining available cash, loans, and real estate owned of the trust were subsequently returned to the Company as payment on the residual interest.

      At December 31, 2002, the Company used a discounted cash flow methodology for determining the fair value of its retained residual interest and residual interest spread (“Residual”). In determining the cash flow of the Residual, the Company assumed a prepayment speed of 15% after the applicable prepayment lockout period and credit losses of 1% or approximately $0.8 million of the total principal balance of the underlying collateral throughout the life of the collateral. These assumptions resulted in an expected weighted average life of the bonds of four months. The value of the resulting Residual cash flows at December 31, 2002, was then determined by applying a discount rate of 9% which, in the Company’s view, was commensurate with the market risk of comparable assets.

Note 4. Debt

      At June 30, 2003, and December 31, 2002, the Company had the following debt:

				2003												2002
												Annual												Annual
				Facility				Amount				Interest				Facility				Amount				Interest
				Amount				Drawn				Cost(1)				Amount				Drawn				Cost(1)
(in thousands)
Notes payable and debentures:
	Unsecured long-term notes payable			$	854,000			$	854,000				7.2	%		$	694,000			$	694,000				7.7	%
	SBA debentures				101,800				94,500				8.1	%			101,800				94,500				8.2	%
	OPIC loan				5,700				5,700				6.6	%			5,700				5,700				6.6	%
		Total notes payable and debentures			961,500				954,200				7.3	%			801,500				794,200				7.8	%
Revolving line of credit					462,500				25,500				11.7	%(2)			527,500				204,250				3.7	%(2)
	Total			$	1,424,000			$	979,700				7.4	%		$	1,329,000			$	998,450				6.9	%

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(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.
(2)	The current interest rate payable on the revolving line of credit was 2.6% and 2.7% at June 30, 2003, and December 31, 2002, respectively, which excludes the annual cost of commitment fees and other facility fees of $2.3 million and $2.0 million, respectively.

S-64

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

  Notes Payable and Debentures

      Unsecured Long-Term 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 June 30, 2003, the notes had remaining maturities of one year 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 May 14, 2003, the Company issued $153 million of five-year and $147 million of seven-year unsecured long-term notes, primarily to insurance companies. The five- and seven-year notes have fixed interest rates of 5.45% and 6.05%, respectively, and have substantially the same terms as the Company’s existing unsecured long-term notes. On May 30, 2003, $140 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 amount.

      SBA Debentures. At June 30, 2003, and December 31, 2002, the Company had debentures payable to the SBA with original terms of ten years and at fixed interest rates ranging from 5.9% to 8.2%. At June 30, 2003, the debentures had remaining maturities of one to nine 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 June 30, 2003, 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 future maturities of notes payable and debentures at June 30, 2003, were as follows:

			Amount Maturing
Year			(in thousands)
2003			$	—
2004				221,000
2005				179,000
2006				180,700
2007				—
Thereafter				373,500
	Total		$	954,200

	Revolving Line of Credit

      On April 18, 2003, the Company renewed its unsecured revolving line of credit. The committed amount under the renewed facility is $462.5 million and may be expanded through new or additional commitments up to $600 million at the Company’s option. The renewed line of credit expires in April 2005 and may be extended under substantially similar terms for one additional year at the Company’s option. The facility bears interest at a rate equal to (i) the one-month LIBOR plus 1.25%, (ii) the Bank of America, N.A. prime rate, or (iii) the Federal Funds rate plus 0.50% at the Company’s option. The interest rate adjusts at the beginning of each new interest period, usually every 30 days. The interest rates were 2.6% and 2.7% at June 30, 2003, and December 31, 2002, respectively, and 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 is $2.3 million. The line of credit generally requires monthly payments of interest, and all principal is due upon maturity.

S-65

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The average debt outstanding on the revolving line of credit was $78.0 million and $68.3 million for the six months ended June 30, 2003, and the year ended December 31, 2002, respectively. The maximum amount borrowed under this facility and the weighted average interest rate for the six months ended June 30, 2003, and the year ended December 31, 2002, were $208.8 million and $216.5 million, and 2.7% and 3.2%, respectively. As of June 30, 2003, the amount available under the revolving line of credit was $399.9 million, net of amounts committed for standby letters of credit of $37.1 million issued under the credit facility.

      The Company has various financial and operating covenants required by the revolving line of credit and the notes payable and debentures. 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 June 30, 2003, the Company was in compliance with these covenants.

Note 5. Guarantees

      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. As of June 30, 2003, and December 31, 2002, the Company had issued guarantees of debt, rental obligations, lease obligations and severance obligations aggregating $58.9 million and $54.6 million, respectively, and had extended standby letters of credit aggregating $37.1 million and $11.3 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 future payments was $96.0 million and $65.9 million at June 30, 2003, and December 31, 2002, respectively. At June 30, 2003, and December 31, 2002, no amounts had been recorded as a liability for the Company’s guarantees or standby letters of credit.

      As of June 30, 2003, the guarantees and standby letters of credit expire as follows:

			Total				2003				2004				2005				2006				2007				After 2007
(in thousands)
Guarantees			$	58,904			$	351			$	54,302			$	395			$	142			$	114			$	3,600
Standby letters of credit				37,093				37				—				4,500				32,556				—				—
	Total		$	95,997			$	388			$	54,302			$	4,895			$	32,698			$	114			$	3,600

Note 6. Preferred Stock

      Allied Investment has 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. The 3% cumulative preferred stock does not have a required redemption date. Allied Investment has the option to redeem in whole or in part the preferred stock by paying the SBA the par value of such securities and any dividends accumulated and unpaid to the date of redemption. The 4% redeemable cumulative preferred stock has a required redemption date in June 2005.

S-66

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 7. Shareholders’ Equity

      Sales of common stock for the six months ended June 30, 2003 and 2002, were as follows:

			For the Six Months
			Ended June 30,
			2003				2002
(in thousands)
Number of common shares				7,050				1,946
Gross proceeds			$	152,632			$	51,800
Less costs including underwriting fees				(7,506	)			(1,880	)
	Net proceeds		$	145,126			$	49,920

      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.

      Dividend reinvestment plan activity for the six months ended June 30, 2003 and 2002, was as follows:

		For the Six Months
		Ended June 30,
		2003				2002
(in thousands, except per share amounts)
Shares issued			154				128
Average price per share		$	21.50			$	24.34

Note 8. Earnings Per Common Share

      Earnings per common share for the three and six months ended June 30, 2003 and 2002, were as follows:

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2003				2002				2003				2002
(in thousands, except per share amounts)
Net increase in net assets resulting from operations		$	59,940			$	73,454			$	79,813			$	129,415
Less preferred stock dividends			(55	)			(55	)			(110	)			(110	)
Income available to common shareholders		$	59,885			$	73,399			$	79,703			$	129,305
Weighted average common shares outstanding — basic			113,539				101,660				111,510				100,822
Dilutive options outstanding to officers			1,013				1,780				781				2,078
Weighted average common shares outstanding — diluted			114,552				103,440				112,291				102,900
Basic earnings per common share		$	0.53			$	0.72			$	0.71			$	1.28
Diluted earnings per common share		$	0.52			$	0.71			$	0.71			$	1.26

Note 9. Dividends and Distributions

      The Company’s Board of Directors declared and the Company paid dividends of $0.57 per common share for each of the first and second quarters of 2003. The dividends totaled $64.5 million

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

and $127.5 million for the three and six months ended June 30, 2003, respectively. The Company paid dividends to common shareholders of $56.2 million and $109.5 million for the three and six months ended June 30, 2002, respectively.

      The Company’s Board of Directors also declared a dividend of $0.57 per common share for the third quarter of 2003.

Note 10. Supplemental Disclosure of Cash Flow Information

      For the six months ended June 30, 2003 and 2002, the Company paid $35.2 million and $34.1 million, respectively, for interest. For the six months ended June 30, 2003, the Company’s non-cash financing activities totaled $3.3 million related to dividend reinvestment. For the six months ended June 30, 2002, the Company’s non-cash financing activities totaled $5.5 million related to stock option exercises and dividend reinvestment.

      Non-cash operating activities for the six months ended June 30, 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 $2.2 million, and receipt of commercial mortgage loans in satisfaction of private finance loans and debt securities of $9.9 million. Non-cash operating activities for the six months ended June 30, 2002, included real estate owned received in connection with foreclosure on commercial mortgage loans of $2.5 million.

Note 11. Hedging Activities

      The Company invests in CMBS 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 BB+ through B rated CMBS bonds and CDO bonds. These transactions, referred to as short sales, involved 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 June 30, 2003, and December 31, 2002, consisted of the following:

(in thousands)
Description of Issue			2003				2002
10-year Treasury securities, due February 2012			$	—			$	52,053
10-year Treasury securities, due November 2012				45,064				107,327
10-year Treasury securities, due February 2013				85,800				—
10-year Treasury securities, due May 2013				8,671				—
5-year Treasury securities, due November 2007				9,959				37,647
5-year Treasury securities, due February 2008				7,492				—
	Total		$	156,986			$	197,027

      As of June 30, 2003, and December 31, 2002, the total obligations to replenish borrowed Treasury securities had increased since the related original sale dates due to changes in the yield on the borrowed Treasury securities, resulting in unrealized depreciation on the obligations of $3.9 million and $7.1 million, respectively. The net proceeds related to the sales of the borrowed Treasury securities were $152.2 million and $189.3 million at June 30, 2003, and December 31, 2002,

S-68

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

respectively. Under the terms of the transactions, the Company has provided additional cash collateral of $5.1 million and $5.4 million at June 30, 2003, and December 31, 2002, respectively, 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 the financial institutions under repurchase agreements. The repurchase agreements are collateralized by U.S. Treasury securities and are settled weekly. As of June 30, 2003, the repurchase agreements were due on July 9, 2003, and had a weighted average interest rate of 0.6%. The weighted average interest rate on the repurchase agreements as of December 31, 2002, was 0.8%.

Note 12. Financial Highlights

			At and for the
			Six Months Ended								At and for the
			June 30,								Year Ended
											December 31,
			2003(3)				2002(3)				2002
Per Common Share Data
Net asset value, beginning of period			$	14.22			$	13.57			$	13.57
	Net investment income(1)			0.78				0.94				1.77
	Net gains (losses)(1)			(0.07	)			0.32				0.43
Net increase in net assets resulting from operations				0.71				1.26				2.20
Net decrease in net assets from shareholder distributions				(1.14	)			(1.08	)			(2.23	)
Net increase in net assets from capital share transactions				0.44				0.27				0.68
Net asset value, end of period			$	14.23			$	14.02			$	14.22
Market value, end of period			$	23.10			$	22.65			$	21.83
Total return				12	%			(9	)%			(7	)%

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(1)	Based on diluted weighted average number of common shares outstanding for the period.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

		At and for the
		Six Months Ended								At and for the
		June 30,								Year Ended
										December 31,
		2003(3)				2002(3)				2002
Ratios and Supplemental Data
Ending net assets		$	1,651,143			$	1,434,453			$	1,546,071
Common shares outstanding at end of period			116,034				102,296				108,698
Diluted weighted average common shares outstanding			112,291				102,900				103,574
Employee and administrative expenses/ average net assets			1.68	%			1.74	%			3.82	%
Total expenses/average net assets			4.02	%			4.26	%			8.75	%
Net investment income/average net assets			5.47	%			6.94	%			12.94	%
Net increase in net assets resulting from operations(2)/average net assets			5.00	%			9.32	%			15.98	%
Portfolio turnover rate			17.26	%			8.33	%			15.12	%
Average debt outstanding		$	927,009			$	940,357			$	938,148
Average debt per share		$	8.26			$	9.14			$	9.06

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(2)	Net changes in unrealized appreciation or depreciation and net realized gains and losses can fluctuate significantly from period to period. As a result, quarterly comparisons may not be meaningful.
(3)	The results for the six months ended June 30, 2003 and 2002, are not necessarily indicative of the operating results to be expected for the full year.

Note 13. Litigation

      During April 2003, the U.S. District Court for the Southern District of New York dismissed a consolidated securities class action lawsuit alleging violations of the federal securities laws filed against the Company and certain of its officers. In its ruling, the court found that the plaintiffs had failed to allege sufficient facts to support their claim and, therefore, dismissed the lawsuit in its entirety.

      The Company is a party to certain other legal proceedings incidental to the normal course of its business, including enforcement of its rights under contracts with its portfolio companies. 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 its financial condition or results of operations.

S-70

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Independent Accountants’ Review Report

The Board of Directors and Shareholders

      We have reviewed the accompanying consolidated balance sheet of Allied Capital Corporation and subsidiaries, including the consolidated statement of investments, as of June 30, 2003, and the related consolidated statements of operations for the three- and six-month periods ended June 30, 2003 and 2002, changes in net assets and cash flows and the financial highlights (included in Note 12) for the six-month periods ended June 30, 2003 and 2002. These consolidated financial statements and financial highlights are the responsibility of the Company’s management.

      We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

      Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements and financial highlights referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

      We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of Allied Capital Corporation and subsidiaries as of December 31, 2002, and the related consolidated statements of operations, changes in net assets and cash flows (not presented herein), and the financial highlights (included in Note 12), for the year then ended; and in our report dated February 11, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2002, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ KPMG LLP

Washington, D.C.

S-71

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NOTICE REGARDING INDEPENDENT PUBLIC ACCOUNTANTS’ REVIEW REPORT

      With respect to the unaudited interim financial information as of June 30, 2003 and for the six-month periods ended June 30, 2003 and 2002, included herein, KPMG LLP has reported that they applied limited procedures in accordance with professional standards for a review of such information. However, their separate report included herein states that they did not audit and they do not express an opinion on that interim financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. The accountants are not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their report on the unaudited interim financial information because that report is not a “report” or a “part” of the registration statement prepared or certified by the accountants within the meaning of Sections 7 and 11 of the Securities Act of 1933.

S-72

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18,000,000 Shares

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We are an internally managed closed-end management investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940.

Our investment objective is to achieve current income and capital gains. We seek to achieve our investment objective by investing primarily in private companies in a variety of industries throughout the United States. No assurances can be given that we will continue to achieve our objective.

Please read this prospectus, and the accompanying prospectus supplement, if any, before investing, and keep it for future reference. It contains important information about us. The SEC maintains an Internet website (http://www.sec.gov) that contains other information about us.

We may offer, from time to time, up to 18,000,000 shares of our common stock in one or more offerings.

The shares of common stock may be offered at prices and on terms to be described in one or more supplements to this prospectus. The offering price per share of our common stock less any underwriting commissions or discounts will not be less than the net asset value per share of our common stock at the time we make the offering.

Our common stock is traded on the New York Stock Exchange under the symbol “ALD.” As of June 11, 2003, the last reported sale price on the New York Stock Exchange for the common stock was $23.94.

	You should review the information, including the risk of leverage, set forth under “Risk Factors” on page 9 of this prospectus before investing in our common stock.

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	Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representations to the contrary is a criminal offense.

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	This prospectus may not be used to consummate sales of shares of common stock unless accompanied by a prospectus supplement.

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June 11, 2003

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      We have not authorized any dealer, salesman or other person to give any information or to make any representation other than those contained or incorporated by reference in this prospectus or any accompanying supplement to this prospectus. You must not rely upon any information or representation not contained or incorporated by reference in this prospectus or the accompanying prospectus supplement as if we had authorized it. This prospectus and any prospectus supplement do not constitute an offer to sell or a solicitation of any offer to buy any security other than the registered securities to which they relate, nor do they constitute an offer to sell or a solicitation of an offer to buy any securities in any jurisdiction to any person to whom it is unlawful to make such an offer or solicitation in such jurisdiction. The information contained in this prospectus and any prospectus supplement is accurate as of the dates on their covers.

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TABLE OF CONTENTS

		Page
Prospectus Summary			1
Fees and Expenses			5
Selected Condensed Consolidated Financial Data			6
Where You Can Find Additional Information			8
Risk Factors			9
Use of Proceeds			16
Price Range of Common Stock and Distributions			17
Management’s Discussion and Analysis of Financial Condition and Results of Operations			18
Senior Securities			45
Business			49
Legal Proceedings			66
Portfolio Companies			67
Determination of Net Asset Value			74
Management			78
Compensation of Executive Officers and Directors			84
Control Persons and Principal Holders of Securities			89
Certain Relationships and Related Party Transactions			91
Tax Status			92
Certain Government Regulations			96
Dividend Reinvestment Plan			100
Description of Capital Stock			101
Plan of Distribution			105
Legal Matters			106
Safekeeping, Transfer and Dividend Paying Agent and Registrar			106
Brokerage Allocation and Other Practices			106
Independent Public Accountants			106
Notice Regarding Arthur Andersen LLP			107
Index to Consolidated Financial Statements			F-1

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ABOUT THIS PROSPECTUS

      This prospectus is part of a registration statement that we have filed with the Securities and Exchange Commission using the “shelf” registration process. Under the shelf registration process, we may offer, from time to time, up to 18,000,000 shares of our common stock on the terms to be determined at the time of the offering. Shares of our common stock may be offered at prices and on terms described in one or more supplements to this prospectus. This prospectus provides you with a general description of the shares of our common stock that we may offer. Each time we use this prospectus to offer shares of our common stock, we will provide a prospectus supplement that will contain specific information about the terms of that offering. The prospectus supplement may also add, update or change information contained in this prospectus. Please carefully read this prospectus and any prospectus supplement together with the additional information described under “Where You Can Find Additional Information” in the Prospectus Summary section and “Risk Factors” before you make an investment decision.

(i)

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PROSPECTUS SUMMARY

      The following summary contains basic information about this offering. It may not contain all the information that is important to an investor. For a more complete understanding of this offering, we encourage you to read this entire document and the documents to which we have referred.

      In this prospectus or any accompanying prospectus supplement, unless otherwise indicated,“Allied Capital”, “we”, “us” or “our” refer to Allied Capital Corporation and its subsidiaries.

BUSINESS (Page 49)

      We are a business development company that participates in the private equity market. We generally invest in illiquid securities through privately negotiated transactions. We provide long-term debt and equity investment capital to support the expansion of companies in a variety of industries. We generally invest in private middle market companies though, from time to time, we may invest in public companies that lack access to public capital or whose securities may not be marginable. We have been investing in businesses for over 40 years and have financed thousands of companies nationwide. Our investment and lending activity is generally focused in two areas:

	•	private finance, and
	•	commercial real estate finance, primarily the investment in non-investment grade commercial mortgage-backed securities.

Our investment portfolio generally includes:

	•	long-term unsecured loans with or without equity features known as mezzanine financing,
	•	equity investments in companies, which may or may not constitute a controlling equity interest,
	•	non-investment grade commercial mortgage-backed securities,

	•	preferred shares in collateralized debt obligations, and
	•	commercial mortgage loans.

      We identify loans and investments through our numerous relationships with:

	•	mezzanine and private equity investors,
	•	investment banks, and
	•	other intermediaries, including professional services firms.

Our credit and investment approval process is centralized at our headquarters in Washington, DC.

      Our tax structure generally allows us to “pass-through” our income to our shareholders through dividends without the imposition of a corporate level of taxation, if certain requirements are met. See “Tax Status.”

      We are an internally managed diversified closed-end management investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940, which we refer to as the 1940 Act. Our investment objective is to achieve current income and capital gains. We seek to achieve our investment objective by investing primarily in private businesses in a variety of industries throughout the United States.

      As a business development company, we are required to meet certain regulatory tests, the most significant relating to our investments and borrowings. A business development company is required to invest at least 70% of its assets in eligible portfolio companies, which includes private or thinly traded public, U.S.-based entities. A business development company must also maintain a coverage ratio of assets to senior securities of at least 200%. See “Certain Government Regulations.”

      Our executive offices are located at 1919 Pennsylvania Avenue, NW,

1

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      Our Internet website address is www.alliedcapital.com. Information contained on our website is not incorporated by reference into this prospectus and you should not consider information contained on our website to be part of this prospectus.

      Our common stock is traded on the New York Stock Exchange under the symbol “ALD.”

DETERMINATION OF

      Our portfolio investments are generally recorded at fair value as determined in good faith by our board of directors in the absence of readily available public market values.

      At December 31, 2002, approximately 89% of our total assets represented portfolio investments recorded at fair value. Pursuant to the requirements of the 1940 Act, we value substantially all of our portfolio investments at fair value as determined in good faith by the board of directors on a quarterly basis. Since there is typically no readily available market value for the investments in our portfolio, our board of directors determines in good faith the fair value of these portfolio investments pursuant to a valuation policy and a consistently applied valuation process.

      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 and record unrealized depreciation for an investment that we believe has become impaired including where collection of a loan or realization of an equity security is doubtful or when the enterprise value of the 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 all debt and equity securities used to capitalize the enterprise at a point in time. Conversely, 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. Without a readily available market value and because of the inherent uncertainty of valuation, 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.

      We adjust quarterly the valuation of our portfolio to reflect the change in the value of each investment in our portfolio. Any changes in value are recorded in our statement of operations as “Net unrealized gains (losses).”

PLAN OF DISTRIBUTION (Page 105)

      We may offer, from time to time, up to 18,000,000 shares of our common stock, on terms to be determined at the time of the offering.

      Shares of our common stock may be offered at prices and on terms described in one or more supplements to this prospectus. The offering price per share of our common stock less any underwriting commission or discount will not be less than the net asset value per share of our common stock at the time we make the offering.

      Our shares of common stock may be offered directly to one or more purchasers,

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      We may not sell shares of common stock without delivering a prospectus supplement describing the method and terms of the offering of such shares.

USE OF PROCEEDS (Page 16)

      We intend to use the net proceeds from selling shares of common stock for general corporate purposes, which include investments in the debt or equity securities of primarily private companies or non-investment grade commercial mortgage-backed securities, repayment of indebtedness, acquisitions and other general corporate purposes. The supplement to this prospectus relating to an offering will more fully identify the use of the proceeds from such offering.

PRICE RANGE OF COMMON STOCK AND DISTRIBUTIONS (Page 17)

      We intend to pay quarterly dividends to holders of our common stock. The amount of our quarterly dividends is determined by our board of directors.

DIVIDEND REINVESTMENT PLAN (Page 100)

      We maintain an “opt in” dividend reinvestment plan for our common shareholders. As a result, if our board of directors declares a dividend, then our new shareholders that have not “opted in” to our dividend reinvestment plan will receive cash dividends. New shareholders must notify our transfer agent in writing if they wish to enroll in the dividend reinvestment plan.

RISK FACTORS (Page 9)

      Investment in our shares of common stock involves certain risks relating to our business and our investment objective that you should consider before purchasing our shares of common stock.

      As a business development company, our portfolio includes securities primarily issued by privately held companies. These investments may involve a high degree of business and financial risk; they are illiquid, and may not produce current returns or capital gains. If we were forced to immediately liquidate some or all of the investments in the portfolio, the proceeds of such liquidation would be significantly less than the current value of such investments. We may be required to liquidate some or all of our portfolio investments to meet our debt service obligations or in the event we are required to fulfill our obligations under agreements pursuant to which we guarantee the repayment of indebtedness by third parties.

      An economic slowdown may affect the ability of a portfolio company to engage in a liquidity event, which is a transaction that involves the sale or recapitalization of all or part of a portfolio company. These conditions could lead to financial losses in our portfolio and a decrease in our revenues, net income and assets. Numerous other factors may affect a borrower’s ability to repay its loan, including the failure to meet its business plan, a downturn in its industry or negative economic conditions.

      We may not borrow money unless we maintain asset coverage for indebtedness of at least 200% which may affect returns to shareholders. We borrow funds to make investments. As a result, we are exposed to the risks of leverage, which may be

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      A large number of entities and individuals compete for the same kind of investment opportunities as we do. Our business of making private equity investments may be affected by current and future market conditions. The absence of an active senior lending environment may slow the amount of private equity investment activity generally. As a result, the pace of our investment activity may slow.

      We may not be able to pay dividends and the loss of pass-through tax treatment could have a material adverse effect on our total return, if any.

      Also, we are subject to certain risks associated with valuing our portfolio, investing in non-investment grade commercial mortgage-backed securities, changing interest rates, accessing additional capital, fluctuating financial results, and operating in a regulated environment.

      Our common stock price may be volatile due to market factors that may be beyond our control.

CERTAIN ANTI-TAKEOVER

      Our charter and bylaws, as well as certain statutory and regulatory requirements, contain certain provisions that may have the effect of discouraging a third party from making an acquisition proposal for Allied Capital. These anti-takeover provisions may inhibit a change in control in circumstances that could give the holders of our common stock the opportunity to realize a premium over the market price for our common stock.

LEGAL PROCEEDINGS (Page 66)

      On April 21, 2003, the U.S. District Court for the Southern District of New York dismissed a consolidated class action lawsuit alleging violations of the federal securities laws filed against us and certain of our officers. In its ruling, the court found that the plaintiffs had failed to allege sufficient facts to support their claim and, therefore, dismissed the lawsuit in its entirety.

      We are a party to certain other lawsuits in the normal course of our business. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.

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FEES AND EXPENSES

     This table describes the various costs and expenses that an investor in our shares of common stock will bear directly or indirectly.

Shareholder Transaction Expenses
	Sales load (as a percentage of offering price)(1)				—%
	Dividend reinvestment plan fees(2)				None
Annual Expenses (as a percentage of consolidated net assets attributable to common stock)(3)
	Operating expenses(4)				3.5%
	Interest payments on borrowed funds(5)				4.6%
		Total annual expenses(6)			8.1%

(1)	In the event that the shares of common stock to which this prospectus relates are sold to or through underwriters, a corresponding prospectus supplement will disclose the applicable sales load.
(2)	The expenses of our dividend reinvestment plan are included in “Operating expenses.” We do not have a stock purchase plan. The participants in the dividend reinvestment plan will bear a pro rata share of brokerage commissions incurred with respect to open market purchases or sales, if any. See “Dividend Reinvestment Plan.”
(3)	“Consolidated net assets attributable to common stock” equals net assets (i.e., total consolidated assets less total consolidated liabilities and preferred stock) at December 31, 2002.
(4)	“Operating expenses” represent our operating expenses for the year ending December 31, 2002 excluding interest on indebtedness.
(5)	The “Interest payments on borrowed funds” represents our interest expenses for the year ending December 31, 2002. We had outstanding borrowings of $998.5 million at December 31, 2002. See “Risk Factors.”
(6)	“Total annual expenses” as a percentage of consolidated net assets attributable to common stock are higher than the total annual expenses percentage would be for a company that is not leveraged. We borrow money to leverage our net assets and increase our total assets. The SEC requires that “Total annual expenses” percentage be calculated as a percentage of net assets, rather than the total assets, including assets that have been funded with borrowed monies. If the “Total annual expenses” percentage were calculated instead as a percentage of consolidated total assets, our “Total annual expenses” would be 4.5% of consolidated total assets.

Example

     The following example, required by the SEC, demonstrates the projected dollar amount of total cumulative expenses that would be incurred over various periods with respect to a hypothetical investment in us. In calculating the following expense amounts, we assumed we would have no additional leverage and that our operating expenses would remain at the levels set forth in the table above. In the event that shares to which this prospectus relates are sold to or through underwriters, a corresponding prospectus supplement will restate this example to reflect the applicable sales load.

		1 Year				3 Years				5 Years				10 Years
You would pay the following expenses on a $1,000 investment, assuming a 5.0% annual return		$	81			$	245			$	410			$	832

     Although the example assumes (as required by the SEC) a 5.0% annual return, our performance will vary and may result in a return of greater or less than 5.0%. In addition, while the example assumes reinvestment of all dividends and distributions at net asset value, participants in the dividend reinvestment plan may receive shares of common stock that we issue at or above net asset value or are purchased by the administrator of the dividend reinvestment plan, at the market price in effect at the time, which may be higher than, at, or below net asset value. See “Dividend Reinvestment Plan.”

The example should not be considered a representation of future expenses, and the actual expenses

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SELECTED CONDENSED CONSOLIDATED FINANCIAL DATA

      You should read the condensed consolidated financial information below with the Consolidated Financial Statements and Notes thereto included in this prospectus. Financial information for the year ended December 31, 2002 has been derived from our financial statements that were audited by KPMG LLP. Financial information for the years ended December 31, 2001, 2000, 1999 and 1998 has been derived from our financial statements that were audited by Arthur Andersen LLP. For important information about Arthur Andersen LLP, see the section entitled “Notice Regarding Arthur Andersen LLP.” See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on page 18 for more information.

				Year Ended December 31,
(in thousands,				2002				2001				2000				1999				1998
except per share data)
Operating Data:
Interest and related portfolio income:
	Interest and dividends			$	264,042			$	240,464			$	182,307			$	121,112			$	80,281
	Premiums from loan dispositions				2,776				2,504				16,138				14,284				5,949
	Post-merger gain on securitization of commercial mortgage loans				—				—				—				—				14,812
	Fees and other income				43,110				46,142				13,144				5,744				5,696
		Total interest and related portfolio income			309,928				289,110				211,589				141,140				106,738
Expenses:
	Interest				70,443				65,104				57,412				34,860				20,694
	Employee				33,126				29,656				26,025				22,889				18,878
	Administrative				21,504				15,299				15,435				12,350				11,921
		Total operating expenses			125,073				110,059				98,872				70,099				51,493
Net investment income before income taxes and net realized and unrealized gains					184,855				179,051				112,717				71,041				55,245
	Income tax expense (benefit)				930				(412	)			—				—				787
Net investment income before net realized and unrealized gains					183,925				179,463				112,717				71,041				54,458
Net realized and unrealized gains:
	Net realized gains				44,937				661				15,523				25,391				22,541
	Net unrealized gains (losses)				(571	)			20,603				14,861				2,138				1,079
		Total net realized and unrealized gains			44,366				21,264				30,384				27,529				23,620
Net increase in net assets resulting from operations				$	228,291			$	200,727			$	143,101			$	98,570			$	78,078
Per Share:
Diluted earnings per common share				$	2.20			$	2.16			$	1.94			$	1.64			$	1.50
Dividends per common share(1)				$	2.23			$	2.01			$	1.82			$	1.60			$	1.43
Weighted average common shares outstanding – diluted(2)					103,574				93,003				73,472				60,044				51,974

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		At December 31,
(in thousands,		2002				2001				2000				1999				1998
except per share data)
Balance Sheet Data:
Portfolio at value		$	2,488,167			$	2,329,590			$	1,788,001			$	1,228,497			$	807,119
Portfolio at cost			2,429,214				2,286,602				1,765,895				1,222,901				803,479
Total assets			2,794,319				2,460,713				1,853,817				1,290,038				856,079
Total debt outstanding(3)			998,450				1,020,806				786,648				592,850				334,350
Preferred stock issued to Small Business Administration(3)			7,000				7,000				7,000				7,000				7,000
Shareholders’ equity			1,546,071				1,352,123				1,029,692				667,513				491,358
Shareholders’ equity per common share (net asset value)		$	14.22			$	13.57			$	12.11			$	10.20			$	8.79
Common shares outstanding at period end(2)			108,698				99,607				85,057				65,414				55,919

		Year Ended December 31,
		2002				2001				2000				1999				1998
Other Data:
Investments funded		$	506,376			$	680,329			$	901,545			$	751,871			$	524,530
Repayments			143,167				74,461				111,031				139,561				138,081
Sales			213,474				129,980				280,244				198,368				81,013
Realized gains			95,562				10,107				28,604				31,536				25,757
Realized losses			(50,625	)			(9,446	)			(13,081	)			(6,145	)			(3,216	)
Return on average assets			9.0%				9.4%				9.1%				9.2%				10.1%
Return on average equity			16.0%				17.0%				17.2%				17.5%				18.0%

(1)	Dividends are based on taxable income, which differs from income for financial reporting purposes.
(2)	Excludes 234,977, 516,779 and 810,456 common shares held in the deferred compensation trust at and for the years ended December 31, 2000, 1999, and 1998, respectively.
(3)	See “Senior Securities” on page 45 for more information regarding our level of indebtedness.

		2002																2001
(in thousands,		Qtr 4				Qtr 3				Qtr 2				Qtr 1				Qtr 4				Qtr 3				Qtr 2				Qtr 1
except per share data)
Quarterly Data (unaudited):
Total interest and related portfolio income		$	78,015			$	76,329			$	73,193			$	82,391			$	82,666			$	72,634			$	68,739			$	65,071
Net investment income before net realized and unrealized gains			42,401				45,094				42,561				53,869				53,428				44,189				42,118				39,728
Net increase in net assets resulting from operations			53,356				45,520				73,454				55,961				42,890				59,703				46,106				52,028
Diluted earnings per common share			0.51				0.44				0.71				0.55				0.43				0.63				0.51				0.60
Dividends declared per common share			0.59				0.56				0.55				0.53				0.51				0.51				0.50				0.49
Net asset value per common share(1)			14.22				13.95				14.02				13.71				13.57				13.42				12.79				12.26

(1)	We determine net asset value per common share as of the last day of the quarter. The net asset values shown are based on outstanding shares at the end of each period.

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WHERE YOU CAN FIND

      We have filed with the SEC a registration statement on Form N-2 together with all amendments and related exhibits under the Securities Act of 1933. The registration statement contains additional information about us and the securities being offered by this prospectus. You may inspect the registration statement and the exhibits without charge at the SEC at 450 Fifth Street, NW, Washington, DC 20549. You may obtain copies from the SEC at prescribed rates.

      We file annual, quarterly and current reports, proxy statements and other information with the SEC. You can inspect our SEC filings, without charge, at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The SEC also maintains a web site at http://www.sec.gov that contains our SEC filings. You can also obtain copies of these materials from the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549, at prescribed rates. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. Copies may also be obtained, after paying a duplicating fee, by electronic request to publicinfo@sec.gov or by written request to Public Reference Section, Washington, DC 20549-0102. You can also inspect reports and other information we file at the offices of the New York Stock Exchange, and you are able to inspect those at 20 Broad Street, New York, NY 10005.

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RISK FACTORS

      Investing in Allied Capital involves a number of significant risks relating to our business and investment objective. As a result, there can be no assurance that we will achieve our investment objective. In addition to the other information contained in this prospectus, you should consider carefully the following information before making an investment in shares of our common stock. In addition to the risk factors described below, other factors that could cause actual results to differ materially include:

	•	the ongoing global economic downturn;
	•	risk associated with possible disruption in our operations due to terrorism; and
	•	future regulatory actions and conditions in our operating areas.

      Investing in private companies involves a high degree of risk. Our portfolio consists of primarily long-term loans to, and investments in, private companies. Investments in private businesses involve a high degree of business and financial risk, which can result in substantial losses and accordingly should be considered speculative. There is generally no publicly available information about the companies in which we invest, and we rely significantly on the diligence of our employees and agents to obtain information in connection with our investment decisions. In addition, some smaller businesses have narrower product lines and market shares than their competition and may be more vulnerable to customer preferences, market conditions, or economic downturns, which may adversely affect the return on, or the recovery of, our investment in such businesses.

      Our portfolio of investments is illiquid. We generally acquire our investments directly from the issuer in privately negotiated transactions. The majority of the investments in our portfolio are typically subject to restrictions on resale or otherwise have no established trading market. We typically exit our investments when the portfolio company has a liquidity event such as a sale, recapitalization, or initial public offering of the company. The illiquidity of our investments may adversely affect our ability to dispose of debt and equity securities at times when it may be otherwise advantageous for us to liquidate such investments. In addition, if we were forced to immediately liquidate some or all of the investments in the portfolio, the proceeds of such liquidation would be significantly less than the current value of such investments. We may be required to liquidate some or all of our portfolio investments to meet our debt service obligations or in the event we are required to fulfill our obligations under agreements pursuant to which we guarantee the repayment of certain indebtedness by third parties.

      Substantially all of our portfolio investments are recorded at fair value as determined in good faith by our board of directors and, as a result, there is uncertainty regarding the value of our portfolio investments. At December 31, 2002, approximately 89% of our total assets represented portfolio investments recorded at fair value. Pursuant to the requirements of the 1940 Act, we value substantially all of our investments at fair value as determined in good faith by our board of directors on a quarterly basis. Since there is typically no readily available market value for the investments in our portfolio, our board of directors determines in good faith the fair value of these investments pursuant to a valuation policy and a consistently applied valuation process.

      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

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      We adjust quarterly the valuation of our portfolio to reflect the board of directors’ determination of the fair value of each investment in our portfolio. Any changes in fair value are recorded in our statement of operations as “Net unrealized gains (losses).”

      Economic recessions or downturns could impair our portfolio companies and harm our operating results. Many of the companies in which we have made or will make investments may be susceptible to economic slowdowns or recessions. An economic slowdown may affect the ability of a company to engage in a liquidity event such as a sale, recapitalization or initial public offering. Our nonperforming assets are likely to increase and the value of our portfolio is likely to decrease during these periods. These conditions could lead to financial losses in our portfolio and a decrease in our revenues, net income, and assets.

      Our business of making private equity investments and positioning them for liquidity events also may be affected by current and future market conditions. The absence of an active senior lending environment may slow the amount of private equity investment activity generally. As a result, the pace of our investment activity may slow. In addition, significant changes in the capital markets could have an effect on the valuations of private companies and on the potential for liquidity events involving such companies. This could affect the amount and timing of gains realized on our investments.

      Our borrowers may default on their payments, which may have an effect on our financial performance. We make long-term unsecured, subordinated loans and invest in equity securities, which may involve a higher degree of repayment risk. We primarily invest in companies that may have limited financial resources and that may be unable to obtain financing from traditional sources. Numerous factors may affect a borrower’s ability to repay its loan, including the failure to meet its business plan, a downturn in its industry, or negative economic conditions. Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in any related collateral.

      Our private finance investments may not produce current returns or capital gains. Private finance investments are typically structured as debt securities with a relatively high fixed rate of interest and with equity features such as conversion rights, warrants, or options. As a result, private finance investments are generally structured to generate interest income from the time they are made and may also produce a realized gain from

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      Our financial results could be negatively affected if Business Loan Express fails to perform as expected. Business Loan Express, Inc. (BLX) is our largest portfolio investment. Our financial results could be negatively affected if BLX, as a portfolio company, fails to perform as expected or if government funding for, or regulations related to, the Small Business Administration 7(a) Guaranteed Loan Program change. At December 31, 2002, the investment totaled $256.8 million at value, or 9.2% of total assets.

      In addition, as controlling shareholder of BLX, we have provided an unconditional guaranty to BLX’s senior credit facility lenders in an amount equal to 50% of BLX’s total obligations on its $124.0 million revolving credit facility. The amount we have guaranteed at December 31, 2002, was $51.6 million. This guaranty can only be called in the event of a default by BLX. We have also provided two standby letters of credit in connection with two term loan securitizations completed by BLX totaling $10.6 million.

      Investments in non-investment grade commercial mortgage-backed securities and collateralized debt obligations may be illiquid, may have a higher risk of default, and may not produce current returns. The commercial mortgage-backed securities and collateralized debt obligation preferred shares in which we invest are not investment grade, which means that nationally recognized statistical rating organizations rate them below the top four investment-grade rating categories (i.e., “AAA” through “BBB”), and are sometimes referred to as “junk bonds.” Non-investment grade commercial mortgage-backed securities and collateralized debt obligation preferred shares tend to be less liquid, may have a higher risk of default and may be more difficult to value. Non-investment grade securities usually provide a higher yield than do investment grade securities, but with the higher return comes greater risk of default. Economic recessions or downturns may cause defaults or losses on collateral securing these securities to increase. Non-investment grade securities are considered speculative, and their capacity to pay principal and interest in accordance with the terms of their issue is not ensured.

      We may not borrow money unless we maintain asset coverage for indebtedness of at least 200%, which may affect returns to shareholders. We must maintain asset coverage for total borrowings of at least 200%. Our ability to achieve our investment objective may depend in part on our continued ability to maintain a leveraged capital structure by borrowing from banks or other lenders on favorable terms. There can be no assurance that we will be able to maintain such leverage. If asset coverage declines to less than 200%, we may be required to sell a portion of our investments when it is disadvantageous to do so. As of December 31, 2002, our asset coverage for senior indebtedness was 270%.

      We borrow money, which magnifies the potential for gain or loss on amounts invested and may increase the risk of investing in us. Borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested and, therefore, increase the risks associated with investing in our securities. We borrow from and issue senior debt securities to banks, insurance companies, and other lenders. Lenders of these senior securities have fixed dollar claims on our consolidated assets that are superior to the claims of our common shareholders. If the value of our consolidated assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more sharply than it would have had we not leveraged. Conversely, if the value of our consolidated assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged. Similarly, any increase in our

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      At December 31, 2002, we had $998.5 million of outstanding indebtedness, bearing a weighted average annual interest cost of 6.9%. In order for us to cover these annual interest payments on indebtedness, we must achieve annual returns on our assets of at least 2.5%.

      Illustration. The following table illustrates the effect of leverage on returns from an investment on our common stock assuming various annual returns, net of expenses. The calculations in the table below are hypothetical and actual returns may be higher or lower than those appearing below. The calculation assumes (i) $2,794.3 million in total assets, (ii) an average cost of funds of 6.9%, (iii) $998.5 million in debt outstanding and (iv) $1,546.1 million of shareholders’ equity.

Assumed Return on Our Portfolio

		-20%				-10%				-5%				0%				5%				10%				20%
Corresponding return to shareholder			-40.7%				-22.6%				-13.6%				-4.6%				4.5%				13.5%				31.6%

      Changes in interest rates may affect our cost of capital and net investment income. Because we borrow money to make investments, our net investment income before net realized and unrealized gains or losses, or net investment income, is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds would increase, which would reduce our net investment income. We use a combination of long-term and short-term borrowings and equity capital to finance our investing activities. We utilize our revolving line of credit as a means to bridge to long-term financing. Our long-term fixed-rate investments are financed primarily with long-term fixed-rate debt and equity. We may use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations. Such techniques may include various interest rate hedging activities to the extent permitted by the 1940 Act. We have analyzed the potential impact of changes in interest rates on interest income net of interest expense. Assuming that the balance sheet were to remain constant and no actions were taken to alter the existing interest rate sensitivity, a hypothetical immediate 1% change in interest rates would have affected the net income by less than 1% over a one year horizon. Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet and other business developments that could affect net increase in assets resulting from operations, or net income. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate.

      We will continue to need additional capital to grow because we must distribute our income. We will continue to need capital to fund incremental growth in our investments.

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      Loss of pass-through tax treatment would substantially reduce net assets and income available for dividends. We have operated so as to qualify as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986. If we meet source of income, diversification, and distribution requirements, we will qualify for effective pass-through tax treatment. For a discussion of the income, diversification and distribution requirements, see “Certain Government Regulations — Regulated Investment Company Status.” We would cease to qualify for such pass-through tax treatment if we were unable to comply with these requirements. In addition, we may have difficulty meeting the requirement to make distributions to our shareholders because in certain cases we may recognize income before or without receiving cash representing such income. If we fail to qualify as a regulated investment company, we will have to pay corporate-level taxes on all of our income whether or not we distribute it, which would substantially reduce the amount of income available for distribution to our stockholders. Even if we qualify as a regulated investment company, we generally will be subject to a corporate-level income tax on the income we do not distribute. Moreover, if we do not distribute at least 98% of our taxable income, we generally will be subject to a 4% excise tax.

      There is a risk that you may not receive dividends or distributions. We intend to make distributions on a quarterly basis to our stockholders. We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, due to the asset coverage test applicable to us as a business development company, we may be limited in our ability to make distributions. Also, our credit facilities limit our ability to declare dividends if we default under certain provisions. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of our status as a regulated investment company. In addition, in accordance with accounting principles generally accepted in the United States of America and tax regulations, we include in income certain amounts that we have not yet received in cash, such as contractual payment-in-kind interest which represents contractual interest added to the loan balance that becomes due at the end of the loan term. The increases in loan balances as a result of contractual payment-in-kind arrangements are included in income in advance of receiving cash payment and are separately included in the change in accrued or reinvested interest and dividends in our consolidated statement of cash flows. Since we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the requirement to distribute at least 90% of our investment company taxable income to maintain our status as a regulated investment company.

      We operate in a competitive market for investment opportunities. We compete for investments with a large number of private equity funds and mezzanine funds, investment

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      We depend on key personnel. We depend on the continued services of our executive officers and other key management personnel. If we were to lose any of these officers or other management personnel, such a loss could result in inefficiencies in our operations and lost business opportunities.

      Changes in the law or regulations that govern us could have a material impact on us or our operations. We are regulated by the SEC and the Small Business Administration. In addition, changes in the laws or regulations that govern business development companies, regulated investment companies, real estate investment trusts, and small business investment companies may significantly affect our business. Any change in the law or regulations that govern our business could have a material impact on us or our operations. Laws and regulations may be changed from time to time, and the interpretations of the relevant laws and regulations also are subject to change.

      Results may fluctuate and may not be indicative of future performance. Our operating results will fluctuate and, therefore, you should not rely on current or historical period results to be indicative of our performance in future reporting periods. Factors that could cause operating results to fluctuate include, among others, variations in the investment origination volume and fee income earned, variation in timing of prepayments, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets, and general economic conditions.

      Our common stock price may be volatile. The trading price of our common stock may fluctuate substantially. The price of our common stock may be higher or lower than the price you pay for your shares, depending on many factors, some of which are beyond our control and may not be directly related to our operating performance. These factors include the following:

	•	price and volume fluctuations in the overall stock market from time to time;
	•	significant volatility in the market price and trading volume of securities of business development companies or other financial services companies;
	•	volatility resulting from trading in derivative securities related to our common stock including puts, calls, long-term equity anticipation securities, or LEAPs, or short trading positions;
	•	changes in regulatory policies or tax guidelines with respect to business development companies or regulated investment companies;
	•	actual or anticipated changes in our earnings or fluctuations in our operating results or changes in the expectations of securities analysts;
	•	general economic conditions and trends;
	•	loss of a major funding source; or
	•	departures of key personnel.

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      Recently, the trading price of our common stock has been volatile. Due to the continued potential volatility of our stock price, we may be the target of securities litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources from our business.

Disclosure Regarding Forward-Looking Statements

      Information contained or incorporated by reference in this prospectus, and the accompanying prospectus supplement, if any, may contain “forward-looking statements” which 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 or similar words or phrases. The matters described in “Risk Factors” and certain other factors noted throughout this prospectus, and the accompanying prospectus supplement, if any, and in any exhibits to the registration statement of which this prospectus, and the accompanying prospectus supplement, if any, is a part, constitute cautionary statements identifying important factors with respect to any such forward-looking statements, including certain risks and uncertainties, that could cause actual results to differ materially from those in such forward-looking statements.

      Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be incorrect. Important assumptions include our ability to originate new investments, maintain certain margins and levels of profitability, access the capital markets for debt and equity capital, the ability to meet regulatory requirements and the ability to maintain certain debt to asset ratios. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this prospectus should not be regarded as a representation by us that our plans and objectives will be achieved. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this prospectus or any accompanying supplement to this prospectus.

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USE OF PROCEEDS

      We intend to use the net proceeds from selling shares of our common stock for general corporate purposes, which include investment in the debt or equity securities of primarily private companies or non-investment grade commercial mortgage-backed securities, repayment of indebtedness, acquisitions and other general corporate purposes. We typically raise new equity when we have attractive investment opportunities. The supplement to this prospectus relating to an offering will more fully identify the use of the proceeds from such offering.

      We anticipate that substantially all of the net proceeds of any offering of shares of our common stock will be used, as described above, within six months, but in no event longer than two years. Pending investment, we intend to invest the net proceeds of any offering of shares of our common stock in time deposits, income-producing securities with maturities of three months or less that are issued or guaranteed by the federal government or an agency of the federal government, and high quality debt securities maturing in one year or less from the time of investment. Our ability to achieve our investment objective may be limited to the extent that the net proceeds of any offering, pending full investment, are held in time deposits and other short-term instruments.

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PRICE RANGE OF COMMON STOCK AND DISTRIBUTIONS

      Our common stock is traded on the New York Stock Exchange under the symbol “ALD.” The following table lists the high and low closing sales prices for our common stock, the closing sales price as a percentage of net asset value (NAV) and quarterly dividends per share. On June 11, 2003, the last reported closing sale price of the common stock was $23.94 per share.

							Closing Sale								Premium				Premium
							Price(2)								of High				of Low
															Sales Price				Sales Price				Declared
			NAV(1)				High				Low				to NAV				to NAV				Dividends
Year ended December 31, 2001
	First Quarter		$	12.26			$	24.44			$	20.13				199	%			164	%		$	0.49
	Second Quarter			12.79				25.40				19.57				199				153				0.50
	Third Quarter			13.42				24.83				21.50				185				160				0.51
	Fourth Quarter			13.57				26.00				21.57				192				159				0.51
Year ending December 31, 2002
	First Quarter		$	13.71			$	28.93			$	25.84				211	%			188	%		$	0.53
	Second Quarter			14.02				27.66				20.88				197				149				0.55
	Third Quarter			13.95				24.49				18.90				176				135				0.56
	Fourth Quarter			14.22				22.87				18.90				161				133				0.56
	Extra Dividend																							0.03
Year ended December 31, 2003
	First Quarter		$	14.05			$	23.18			$	19.44				165	%			138	%		$	0.57
	Second Quarter (through June 11, 2003)			*				25.16				19.85				*				*				0.57

(1)	Net asset value per share is determined as of the last day in the relevant quarter and therefore may not reflect the net asset value per share on the date of the high and low sales prices. The net asset values shown are based on outstanding shares at the end of each period.
(2)	Prior to June 6, 2001, our common stock was traded on the Nasdaq National Market under the symbol “ALLC.” The closing sale prices listed are as reflected on the respective exchanges for the periods presented.
*	Net asset value has not yet been calculated for this period.

     Our common stock continues to trade in excess of net asset value. There can be no assurance, however, that we will maintain a premium to net asset value.

      We intend to pay quarterly dividends to shareholders of our common stock. The amount of our quarterly dividends is determined by our board of directors. Our board of directors has established a dividend policy to review the dividend rate quarterly, and may adjust the quarterly dividend rate throughout the year. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Equity Capital and Dividends” and “Tax Status.” We cannot assure that we will achieve investment results or maintain a tax status that will permit any particular level of dividend payment. Our credit facilities limit our ability to declare dividends if we default under certain provisions.

      We maintain an “opt in” dividend reinvestment plan for our common shareholders. As a result, if our board of directors declares a dividend, then our new shareholders will receive cash dividends, unless they specifically “opt in” to the dividend reinvestment plan to reinvest their dividends and receive additional shares of common stock. See “Dividend Reinvestment Plan.”

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MANAGEMENT’S DISCUSSION AND ANALYSIS

      The information contained in this section should be read in conjunction with our 2002 Consolidated Financial Statements and the Notes thereto. In addition, this prospectus 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 above in the Risk Factors section. Other factors that could cause actual results to differ materially include:

	•	the ongoing global economic downturn;
	•	risks associated with possible disruption in our operations due to terrorism; and
	•	future regulatory actions and conditions in our operating areas.

      Financial or other information presented for private finance portfolio companies has been obtained from the portfolio company, and the financial information presented may represent unaudited, projected or pro forma financial information, and therefore may not be indicative of actual results.

OVERVIEW

      We are a business development company that provides long-term debt and equity investment capital to support the expansion of 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. 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, buyouts, acquisitions, recapitalizations, note purchases, and bridge financings. We generally invest in private companies though, from time to time, we may invest in public companies that lack access to public capital or whose securities may not be marginable.

      Our portfolio composition at December 31, 2002, 2001, and 2000, was as follows:

		2002				2001				2000
Private Finance			70	%			68	%			72	%
Commercial Real Estate Finance			30	%			32	%			28	%

      Our earnings depend primarily on the level of interest and dividend income, fee income, and net realized and unrealized gains or losses earned on our investment portfolio after deducting interest paid on borrowed capital and operating expenses. Interest income results from the stated interest rate earned on a loan and the amortization of loan

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PORTFOLIO AND INVESTMENT ACTIVITY

      Total portfolio investment activity and yields at and for the years ended December 31, 2002, 2001, and 2000, were as follows:

		2002				2001				2000
($ in millions)
Portfolio at value		$	2,488.2			$	2,329.6			$	1,788.0
Investments funded		$	506.4			$	680.3			$	901.5
Change in accrued or reinvested interest and dividends		$	44.7			$	51.6			$	32.2
Principal repayments		$	143.2			$	74.5			$	111.0
Sales(1)		$	213.5			$	130.0			$	280.2
Yield(2)			14.0	%			14.3	%			14.1	%

(1)	Sales for the year ended December 31, 2000, include $128.5 million of small business loans sold.
(2)	The weighted average yield on interest-bearing investments is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount, and market discount earned on accruing interest-bearing investments, 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, investment activity, and yields at and for the years ended December 31, 2002, 2001, and 2000, were as follows:

			2002				2001				2000
($ in millions)
Portfolio at value:
	Loans and debt securities		$	1,151.2			$	1,107.9			$	966.3
	Equity interests			592.0				487.2				316.2
Total portfolio			$	1,743.2			$	1,595.1			$	1,282.5
Investments funded			$	297.2			$	287.7			$	600.9
Change in accrued or reinvested interest and dividends			$	42.6			$	48.9			$	31.8
Principal repayments			$	129.3			$	43.8			$	75.7
Yield*				14.4	%			14.8	%			14.6	%

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

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     Investments funded for the years ended December 31, 2002, 2001, and 2000, consisted of the following:

				Loans and
				Debt				Equity
				Securities				Interests				Total
($ in millions)
For the Year Ended December 31, 2002(1)
	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
For the Year Ended December 31, 2001(1)
	Companies more than 25% owned			$	47.8			$	78.3			$	126.1
	Companies 5% to 25% owned				13.5				4.5				18.0
	Companies less than 5% owned				136.9				6.7				143.6
		Total		$	198.2			$	89.5			$	287.7
For the Year Ended December 31, 2000(1)
	Companies more than 25% owned			$	10.8			$	111.5			$	122.3
	Companies 5% to 25% owned				121.8				42.7				164.5
	Companies less than 5% owned				288.7				25.4				314.1
		Total		$	421.3			$	179.6			$	600.9

(1)

The private finance portfolio is presented in three categories — companies more than 25% owned, which represent portfolio companies where we directly or indirectly own more than 25% of the outstanding voting securities of such portfolio company and, therefore, are deemed controlled by us under the Investment Company Act of 1940, or the 1940 Act; companies owned 5% to 25%, which represent portfolio companies where we directly or indirectly own 5% to 25% of the outstanding voting securities of such portfolio company or where we hold 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 we directly or indirectly own less than 5% of the outstanding voting securities of such portfolio company and where we have no other affiliations with such portfolio company.

     At December 31, 2002, we had outstanding funding commitments of $92.8 million to portfolio companies, including $25.7 million committed to private venture capital funds. At December 31, 2002, we also had total commitments to private finance portfolio companies in the form of standby letters of credit and guarantees of $65.9 million.

      We fund new investments using cash, through the issuance of our common equity, 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 providing a subsequent investment.

      We may acquire more than 50% of the common stock of a company in a control buyout transaction. Control investments are generally structured such that we earn a current return through a combination of interest income on our senior loans and subordinated debt, dividends on our preferred and common stock, and management or transaction services fees to compensate us for the managerial assistance that we provide to a controlled portfolio company. In some cases for companies that are more than 50%

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      Business Loan Express, Inc.     At December 31, 2002, our investment in BLX totaled $221.4 million at cost and $256.8 million at value, or 9.2% of our total assets, which includes unrealized appreciation of $35.4 million.

      BLX is the nation’s second largest non-bank government guaranteed 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 preferred lender as designated by the SBA in 68 markets across the United States, and originates, sells, and services small business loans. In addition to the 7(a) Guaranteed Loan Program, BLX originates conventional small business loans and originates loans under the USDA Business and Industry Guaranteed Loan Program. BLX has offices across the United States and is headquartered in New York, New York.

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      Summary financial data for BLX at and for the six months ended December 31, 2002, and their year ended June 30, 2002, was as follows:

			At and for the				At and for the
			Six Months Ended				Year Ended
			December 31, 2002(1)				June 30, 2002
($ in millions)
Operating Data
	Total revenue		$	51.1			$	84.6
	Profits before taxes(4)		$	1.6			$	3.6
	Earnings before interest, taxes and management fees (EBITM)(4)		$	24.5			$	43.0
Balance Sheet Data
	Total assets(2)		$	290.8			$	277.1
	Total debt		$	194.9			$	183.0
	Total shareholders’ equity		$	60.4			$	59.9
Cash Flow Data
	Cash provided by operating activities		$	8.0			$	18.7
	Cash used in investing activities		$	(14.3	)		$	(37.1	)
	Cash provided by financing activities		$	7.0			$	3.0
Other Data
	Total loan originations		$	308.8			$	565.1
	Serviced loan portfolio		$	1,619.5			$	1,372.6
	Number of loans			2,373				2,083
	Loan delinquencies(3)			8.6	%			9.4	%
Serviced Loan Portfolio by Industry
	Hotels			26	%			27	%
	Gas stations/convenience stores			19				16
	Restaurants			10				10
	Manufacturing and industrial			10				10
	Professional and retail services			9				10
	Shrimp/fishing vessels			6				7
	Recreation			5				5
	Child care and health care services			4				4
	Other			11				11
	Total			100	%			100	%

(1)	The results of operations, changes in cash flows, and loan originations for the six months ended December 31, 2002, are not necessarily indicative of the operating results to be expected for the full year.
(2)	Included in total assets is $6 million of goodwill. There is no other goodwill on BLX’s balance sheet. We acquired 94.9% of BLC Financial Services, Inc. on December 31, 2000. “Push-down” accounting was not required with respect to this transaction; accordingly, goodwill was not recorded by BLX.
(3)	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 8.7% at December 31, 2002.
(4)	BLX incurred certain one-time expenses of approximately $1 million for the six months ended December 31, 2002, associated with the Amresco Independence Funding transaction and its reorganization to an LLC.

     BLX sells or securitizes substantially all of the loans it originates. BLX currently 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%

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      As a result of BLX’s guaranteed loan sales and securitization transactions, BLX had assets at December 31, 2002, of approximately $124.3 million representing the residual interests in and servicing assets for loans sold or securitized, together referred to as Residual Interests. These Residual Interests represent the discounted present value of estimated future cash flow streams to be received from loans sold or securitized after making allowances for estimated prepayments, losses, and loan delinquencies.

      If scheduled loan payments on all loans were to be received as stated in the loan agreements, estimated future cash flows to BLX from loans sold or securitized would total approximately $499.7 million in the aggregate over the remaining term of these loans. Of the approximate $499.7 million, estimated cash flows for the 12 months ended December 31, 2003, 2004, 2005, and 2006, would be approximately $38.5 million, $37.2 million, $36.3 million, and $35.3 million, respectively, although there can be no assurance that scheduled loan payments will approximate actual cash received.

      The loans originated by BLX are generally secured by commercial real estate. Loans originated under the SBA 7(a) Guaranteed Loan Program also require the personal guarantee of the borrower and, in many cases, the loans are also secured by additional real estate collateral. Because the loans are secured by collateral, BLX’s annual loan losses for its serviced SBA 7(a) loans, computed using the unguaranteed balance of the SBA 7(a) loan portfolio, were less than 1% on average for the last five fiscal years.

      Because of the government guarantee attached to SBA 7(a) loans, BLX’s loss of principal exposure to loans greater than 90 days delinquent at December 31, 2002, was $38.4 million in the aggregate. At December 31, 2002, BLX has accrued loss reserves of $10.6 million, which when deducted from 90-day delinquencies would reduce their unreserved financial exposure to 90-day delinquencies to $27.8 million. BLX’s reserves represent 28% of over 90-day delinquent loans. BLX’s loans are underwritten to have substantial collateral coverage and also carry personal guarantees of the borrowers.

      BLX’s sources of cash flow from operations include net income, cash proceeds from loan sales net of cash used for loans originated, and changes in working capital. BLX’s cash used in investing activities includes the origination of residual interests from loans sold, net of collections of residual interests, and cash used to purchase fixed assets.

      BLX has a three-year $124 million revolving credit facility that matures in March 2004. As the controlling shareholder of BLX, we have provided an unconditional guaranty to the revolving credit facility lenders in an amount of up to 50% of the total obligations (consisting of principal, accrued interest, and other fees) of BLX under the revolving credit facility. The amount guaranteed by us at December 31, 2002, was $51.6 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, 2002.

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      In January 2003, BLX announced the completion of a $128.0 million acquisition of performing loans and other assets from Amresco Independence Funding. BLX purchased $121.5 million of performing loans at par and other assets purchased totaled $6.5 million. The acquisition has increased BLX’s serviced portfolio to over $2 billion, and BLX now serves in excess of 2,800 small business borrowers. We provided $50 million of the capital to fund this acquisition. Our $50 million financing was in the form of a short-term revolving credit facility of $25 million to fund the temporary capital needs of construction loans purchased and loans pending sale, as well as $25 million of preferred equity to support the future growth potential of the company post acquisition.

      In February 2003, BLX completed a corporate reorganization to a limited liability company. As BLX LLC moves forward, its taxable earnings will flow directly to its members and we represent approximately 95% of the economic interests in the LLC. In connection with the reorganization, BLX has changed its fiscal year end to September 30.

      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 impact on BLX or its operations. As of October 1, 2002, the SBA implemented a maximum loan size of $500,000 for loans originated through the SBA 7(a) Guaranteed Loan Program due to Federal budget constraints. In February 2003, legislation was enacted to return the SBA 7(a) Guaranteed Loan Program to a sufficient level of funding. This legislation has enabled the SBA to return the maximum loan size to previous levels.

      The Hillman Companies, Inc. At December 31, 2002, our investment in Hillman totaled $92.6 million at cost and $180.5 million at value, or 6.5% of total assets. During the fourth quarter of 2002, Hillman distributed $6.5 million of preferred stock in STS Operating, Inc. (STS) to us, which reduced our cost basis in Hillman’s common stock and added to our investment in STS.

      Hillman is a leading manufacturer of key making equipment and distributor of key blanks, fasteners, signage, and other small hardware components and operates in multiple channels of the retail marketplace such as hardware stores, national and regional home centers, and mass merchants. Hillman has certain patent-protected products, including key duplication technology, that is important to its business. Hillman’s primary operations are located in Cincinnati, Ohio.

      For the year ended December 31, 2002, Hillman had total revenue of $286.8 million, earnings before interest, taxes, depreciation, amortization, and management fees, or EBITDAM, of $50.2 million, and profits before taxes of $10.0 million. Hillman had total assets of $368.9 million and total debt of $146.7 million at December 31, 2002.

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Commercial Real Estate Finance

      The commercial real estate finance portfolio, investment activity, and yields at and for the years ended December 31, 2002, 2001, and 2000, were as follows:

($ in millions)			2002				2001				2000
Portfolio at value:
	CMBS bonds		$	555.5			$	558.3			$	311.3
	CDO preferred shares			52.8				24.2				—
	Commercial mortgage loans			63.7				79.6				106.4
	Residual interest			69.0				69.9				81.7
	Real estate owned			4.0				2.5				6.1
Total portfolio			$	745.0			$	734.5			$	505.5
Investments funded			$	209.2			$	392.6			$	149.0
Change in accrued or reinvested interest			$	2.1			$	2.7			$	1.1
Principal repayments			$	13.9			$	30.7			$	24.3
CMBS and commercial real estate loan sales			$	213.5			$	130.0			$	151.7
Yield*				13.4	%			13.5	%			13.1	%

*

The weighted average yield on the interest-bearing investments is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount, and market discount earned on accruing interest-bearing investments, 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.

     Our primary commercial real estate finance investment activity is the investment in non-investment grade commercial mortgage-backed securities, or CMBS. We believe that CMBS is an attractive asset class because of the yields that can be earned on securities that are secured by commercial mortgage loans and ultimately commercial real estate properties. Our CMBS investment activity level will be dependent upon our ability to invest in CMBS at attractive yields. We plan to continue our CMBS investment activity; however, in order to maintain a balanced portfolio, we expect that CMBS will not exceed 25% of our total assets.

      Our commercial real estate investment activity for the years ended December 31, 2002, 2001, and 2000, was as follows:

			Face								Amount
			Amount				Discount				Funded				Yield(1)(2)
($ in millions)
For the Year Ended December 31, 2002
CMBS bonds			$	302.5			$	(140.2	)		$	162.3				13.4	%
CDO preferred shares				29.0				—				29.0				17.5	%
Commercial mortgage loans				11.7				(1.7	)			10.0				13.5	%
Real estate owned				7.9				—				7.9
	Total		$	351.1			$	(141.9	)		$	209.2				14.0	%
For the Year Ended December 31, 2001
CMBS bonds			$	661.4			$	(295.6	)		$	365.8				14.0	%
CDO preferred shares				24.6				—				24.6				16.9	%
Commercial mortgage loans				2.2				—				2.2				10.0	%
	Total		$	688.2			$	(295.6	)		$	392.6				14.2	%

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			Face								Amount
			Amount				Discount				Funded				Yield(1)(2)
($ in millions)
For the Year Ended December 31, 2000
CMBS bonds			$	244.6			$	(120.3	)		$	124.3				14.7	%
Commercial mortgage loans				25.5				(0.8	)			24.7				10.9	%
	Total		$	270.1			$	(121.1	)		$	149.0				14.1	%

(1)	The yield on new CMBS bond investments will vary from period to period depending on the concentration of lower yielding BB+, BB, and BB– CMBS bonds purchased in that period to the total amount invested.
(2)	Total yield calculation excludes new investments in real estate owned.

     CMBS Bonds. The non-investment grade and unrated tranches of 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 generally is allocated first to the senior tranches, 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 resulting in reduced cash flows, our most subordinate tranche will bear this loss first. At December 31, 2002, our CMBS bonds were subordinate to 91% to 97% of the tranches of bonds issued in various CMBS transactions. Given that the non-investment grade CMBS bonds in which we invest are junior in priority for payment of principal and interest, 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, 2002, 2001, and 2000, the average discount for the CMBS bonds in which we invested was 46%, 45%, and 49%, respectively.

      The underlying pools of mortgage loans that are collateral for our new CMBS bond investments for the years ended December 31, 2002, 2001, and 2000, had respective underwritten loan to value and underwritten debt service coverage ratios as follows:

		2002								2001								2000
Loan to Value Ranges		Amount				Percentage				Amount				Percentage				Amount				Percentage
($ in millions)
Less than 60%		$	909.3				20	%		$	1,259.7				15	%		$	577.1				14	%
60-65%			287.3				6				941.6				11				402.8				10
65-70%			587.9				13				1,140.6				14				648.1				16
70-75%			1,214.5				27				2,400.4				29				1,450.9				36
75-80%			1,477.5				33				2,466.4				30				958.9				23
Greater than 80%			47.8				1				119.6				1				36.6				1
Total		$	4,524.3				100	%		$	8,328.3				100	%		$	4,074.4				100	%
Weighted average loan to value			68.5	%							69.7	%							70.2	%

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		2002								2001								2000
Debt Service Coverage
Ratio(1) Ranges		Amount				Percentage				Amount				Percentage				Amount				Percentage
($ in millions)
Greater than 2.00		$	366.9				8	%		$	484.8				6	%		$	197.0				5	%
1.76-2.00			229.6				5				158.2				2				99.1				3
1.51-1.75			477.4				11				855.0				10				341.8				8
1.26-1.50			2,739.6				60				5,008.3				60				2,204.5				54
Less than 1.25			710.8				16				1,822.0				22				1,232.0				30
Total		$	4,524.3				100	%		$	8,328.3				100	%		$	4,074.4				100	%
Weighted average debt service coverage ratio			1.41								1.48								1.35

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(1)	Defined as annual net cash flow before debt service divided by annual debt service payments.

      As a part of our strategy to maximize our return on equity capital, we sold CMBS bonds rated BB+ through B during the year ended December 31, 2002, with a cost basis of $205.9 million, and bonds rated BB+ through BB-during the years ended December 31, 2001 and 2000, with a cost basis of $124.5 million and $98.7 million, respectively. These bonds had a weighted average effective yield of 11.5%, 10.3%, and 11.5% and were sold for $225.6 million, $126.8 million, and $102.5 million, respectively, resulting in realized gains on the sales. The sales of these primarily lower yielding bonds increased our overall liquidity.

      The effective yield on our CMBS bond portfolio at December 31, 2002, 2001, and 2000, was 14.2%, 14.7%, and 15.4%, respectively. The yield on the CMBS bond portfolio at any point in time will vary depending on the concentration of lower yielding BB+, BB, and BB- CMBS bonds held in the portfolio. At December 31, 2002, 2001, and 2000, the unamortized discount related to the CMBS bond portfolio was $649.5 million, $611.9 million, and $364.9 million, respectively. At December 31, 2002, the CMBS bond portfolio had a fair value of $555.5 million, which included net unrealized appreciation on the CMBS bonds of $31.8 million.

      During January 2003, we sold BB+ through B CMBS bonds with a cost basis of $115.7 million for $128.8 million in cash proceeds. We recognized a gain on this sale of $12.2 million, net of a realized loss of $0.9 million from a hedge related to the CMBS bonds sold. After completion of this sale, the CMBS bond portfolio yield increased to approximately 15%. However, the yield on the CMBS bond portfolio will continue to fluctuate as we invest in more CMBS bond issuances that contain higher rated, lower yielding BB+, BB, and BB-bonds.

      At December 31, 2002, the underlying pools of mortgage loans that are collateral for our CMBS bonds consisted of approximately 4,500 commercial mortgage loans with a total outstanding principal balance of $25.0 billion. At December 31, 2002 and 2001, 1.0% and 0.5%, respectively, of the loans in the underlying collateral pool for our CMBS bonds were over 30 days delinquent or were classified as real estate owned.

      Collateralized Debt Obligation Preferred Shares. During the years ended December 31, 2002 and 2001, we invested in the preferred shares of three and one, respectively, collateralized debt obligations, or CDOs, which are secured by investment grade unsecured debt issued by various real estate investment trusts, or REITs, and investment and non-investment grade CMBS bonds. The investment grade REIT collateral consists of debt with a cut-off balance of $1,017.6 million and was issued by 42 REITs. The investment grade CMBS collateral consists of CMBS bonds with a face amount of $479.0 million issued in 39 separate CMBS transactions. The non-investment grade CMBS

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      Commercial Mortgage Loans and Real Estate Owned. Since 1998, we have been liquidating much of our whole commercial mortgage loan portfolio so that we can redeploy the proceeds into higher yielding assets. For the years ended December 31, 2002, 2001, and 2000, we sold $7.5 million, $5.5 million, and $53.0 million, respectively, of commercial mortgage loans and real estate owned. At December 31, 2002, our whole commercial mortgage loan portfolio had been reduced to $63.7 million from $79.6 million at December 31, 2001.

      Residual Interests. The residual interest primarily consists of a retained interest from a 1998 asset securitization whereby bonds were sold in three classes rated AAA, AA and A. The residual interest represents a right to cash flows from the underlying collateral pool of loans after these senior bond obligations are satisfied. At December 31, 2002, one class of bonds rated AAA was outstanding totaling $17.6 million. We have the right to call the bonds upon a minimum of ten days notice to the bondholders. Once the bonds are fully repaid, either through the cash flows from the securitized loans or due to us calling the bonds, the remaining loans in the trust will be returned to us as payment on the residual interest. At December 31, 2002, the value of the cash, loans and REO in the trust totaled $86.6 million.

Portfolio Asset Quality

      Portfolio by Grade. We employ a standard grading system for the 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 interest or principal is expected. Grade 4 is used for investments that are in workout and for which some loss of current interest 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, 2002 and 2001, our portfolio was graded as follows:

		2002								2001
						Percentage								Percentage
		Portfolio				of Total				Portfolio				of Total
Grade		at Value				Portfolio				at Value				Portfolio
($ in millions)
1		$	801.0				32.1	%		$	603.3				25.9	%
2			1,400.8				56.3				1,553.8				66.7
3			166.0				6.7				79.5				3.4
4			23.6				1.0				44.5				1.9
5			96.8				3.9				48.5				2.1
		$	2,488.2				100.0	%		$	2,329.6				100.0	%

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      Total Grades 4 and 5 assets as a percentage of the total portfolio at value at December 31, 2002 and 2001, were 4.9% and 4.0%, respectively. Included in Grades 4 and 5 assets at December 31, 2002 and 2001, were assets totaling $24.1 million and $6.6 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 Grades 4 and 5 may fluctuate from period to period. We continue to follow our historical practice of working with a troubled portfolio company in order to recover the maximum amount of our investment, but record unrealized depreciation for the expected amount of the loss when such exposure is identified.

      At December 31, 2002, we saw an increase in Grade 3 assets in this difficult economy. We have been working with a number of portfolio companies that are in the process of restructuring their operations or balance sheets due to changes in the economic environment or other changes in their business, and we have classified investments in these types of situations in Grade 3 because they are close monitoring situations. We may record some depreciation on a Grade 3 investment to reflect any decline in value while the company is in a close monitoring situation; however, we currently do not expect a loss of investment return or principal for these assets.

      Loans and Debt Securities on Non-Accrual Status. Loans and debt securities on non-accrual status for which we have doubt about interest collection and are in workout status are classified as Grade 4 or 5 assets. In addition, we may not accrue interest on loans and debt securities to companies that are more than 50% owned by us from time to time if such companies are in need of additional capital. In these situations we may choose to defer current debt service.

      For the total investment portfolio, workout loans and debt securities (which excludes equity securities that are included in the total Grade 4 and 5 assets above) not accruing interest that were classified in Grade 4 and 5 were $89.1 million at value at December 31, 2002, or 3.6% of the total portfolio. Included in this category at December 31, 2002, were loans of $13.0 million that were secured by commercial real estate. Workout loans and debt securities not accruing interest were $85.0 million at value at December 31, 2001, or 3.6% of the total portfolio, of which $8.9 million was related to portfolio companies in liquidation and $4.1 million represented loans secured by commercial real estate. As of December 31, 2002, $7.6 million representing receivables related to portfolio companies in liquidation were included in other assets. In addition to Grade 4 and 5 assets that are in workout, loans and debt securities to companies that are more than 50% owned by us that were not accruing interest totaled $63.6 million at value at December 31, 2002, and loans and debt securities to companies that are less than 50% owned by us that were not in workout but were not accruing interest totaled $7.2 million and $23.9 million at value at December 31, 2002 and 2001, respectively.

      Loans and Debt Securities Over 90 Days Delinquent. Loans and debt securities greater than 90 days delinquent were $103.1 million at value at December 31, 2002, or 4.1% of the total portfolio. Included in this category were loans valued at $26.0 million that were secured by commercial real estate. Loans and debt securities greater than 90 days delinquent were $39.1 million at value at December 31, 2001, or 1.7% of the total portfolio. Included in this category were loans valued at $14.1 million that were secured by commercial real estate.

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      As a provider of long-term privately negotiated investment capital, we may defer payment of principal or interest from time to time. As a result, the amount of the portfolio that is greater than 90 days delinquent or on non-accrual status may vary from quarter to quarter. The nature of our private finance portfolio company relationships frequently provide an opportunity for portfolio companies 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. 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 investments for a total return including interest or dividends plus capital gains from the sale of equity securities. Therefore, the amount of loans greater than 90 days delinquent or on non-accrual status 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.

Hedging Activities

      Because we invest in BB+ through B rated CMBS bonds, which were purchased at prices 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 these CMBS bonds. These transactions, referred to as short sales, involved receiving the proceeds from the sales of borrowed Treasury securities, with the obligations 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 and 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, which are limited only by the increase in value of the borrowed Treasury securities; conversely, the value of the CMBS bonds would likely increase. If the value of the borrowed Treasury securities decreases, we will incur gains on these transactions, which are limited only by the decline in value of the borrowed Treasury securities; conversely, the value of the CMBS 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 $197.0 million and $47.3 million at December 31, 2002 and 2001, respectively, which included unrealized depreciation on the obligations of $7.1 million and unrealized appreciation on the obligations of $1.2 million, respectively, due to changes in the yield on the borrowed Treasury securities. The net proceeds related to the sales of the borrowed Treasury securities were $189.3 million and $48.5 million at December 31, 2002 and 2001, respectively. Under the terms of the transactions, we have provided additional cash collateral of $5.4 million at December 31, 2002, for the difference between the net proceeds related to the sales of the borrowed Treasury securities and the obligations to replenish the securities on the weekly settlement date, which is included in deposits of proceeds from sales of borrowed Treasury securities in the accompanying financial statements.

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RESULTS OF OPERATIONS

Comparison of the Years Ended December 31, 2002, 2001, and 2000

      The following table summarizes our condensed operating results for the years ended December 31, 2002, 2001, and 2000.

																Percent																Percent
				2002				2001				Change				Change				2001				2000				Change				Change
(in thousands, except per share amounts)
Interest and Related Portfolio Income
	Interest and dividends			$	264,042			$	240,464			$	23,578				10	%		$	240,464			$	182,307			$	58,157				32	%
	Premiums from loan dispositions				2,776				2,504				272				11	%			2,504				16,138				(13,634	)			(84	)%
	Fees and other income				43,110				46,142				(3,032	)			(7	)%			46,142				13,144				32,998				251	%
		Total interest and related portfolio income			309,928				289,110				20,818				7	%			289,110				211,589				77,521				37	%
Expenses
	Interest				70,443				65,104				5,339				8	%			65,104				57,412				7,692				13	%
	Employee(1)				33,126				29,656				3,470				12	%			29,656				26,025				3,631				14	%
	Administrative(1)				21,504				15,299				6,205				41	%			15,299				15,435				(136	)			(1	)%
		Total operating expenses			125,073				110,059				15,014				14	%			110,059				98,872				11,187				11	%
		Net investment income before income taxes and net realized and unrealized gains			184,855				179,051				5,804				3	%			179,051				112,717				66,334				59	%
		Income tax expense (benefit)			930				(412	)			1,342				(326	)%			(412	)			—				(412	)			—
		Net investment income before net realized and unrealized gains			183,925				179,463				4,462				2	%			179,463				112,717				66,746				59	%
Net Realized and Unrealized Gains
	Net realized gains				44,937				661				44,276				*				661				15,523				(14,862	)			*
	Net unrealized gains (losses)				(571	)			20,603				(21,174	)			*				20,603				14,861				5,742				*
		Total net realized and unrealized gains			44,366				21,264				23,102				*				21,264				30,384				(9,120	)			*
Net income				$	228,291			$	200,727			$	27,564				14	%		$	200,727			$	143,101			$	57,626				40	%
Diluted earnings per common share				$	2.20			$	2.16			$	0.04				2	%		$	2.16			$	1.94			$	0.22				11	%
Weighted average common shares outstanding — diluted					103,574				93,003				10,571				11	%			93,003				73,472				19,531				27	%

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	*	Net realized and net unrealized gains and losses can fluctuate significantly from year to year. As a result, annual comparisons of net realized and net unrealized gains and losses may not be meaningful.

(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 income results from total interest and related portfolio income earned, less total expenses incurred in our operations, plus or minus net realized and unrealized gains (losses).

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

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      The increase in interest and dividend income earned resulted primarily from the growth of our investment portfolio and the dividends earned on certain equity securities. The level of interest income is directly related to the balance of the interest-bearing investment portfolio multiplied by the weighted average yield. The weighted average yield varies from period to period based on the current stated interest rate earned on interest-bearing investments and the amount of loans and debt securities for which interest is not accruing. Our interest-bearing investments in the portfolio increased by 2.9% to $1,896.2 million at December 31, 2002, from $1,842.4 million at December 31, 2001, and increased by 25.2% during 2001 from $1,471.8 million at December 31, 2000. The weighted average yield on the interest-bearing investments in the portfolio at December 31, 2002, 2001, and 2000, was as follows:

      Included in premiums from loan dispositions are prepayment premiums of $2.8 million, $2.0 million, and $2.8 million for the years ended December 31, 2002, 2001, and 2000, 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. Because we seek to finance primarily seasoned, performing companies, such companies at times can secure lower cost financing as their balance sheets strengthen or as more favorable interest rates become available, or a company may enter into a transaction that triggers the early repayment of their debt to us. Therefore, we generally structure our loans to require a prepayment premium for the first three to five years of the loan. Premiums from loan dispositions for the year ended December 31, 2000, included premiums from loan sales of $13.3 million primarily due to the loan sale activities of our small business lending operation prior to its merger with BLX at the end of 2000.

      Fees and other income primarily include fees related to financial structuring, diligence, transaction services, management services to portfolio companies, guaranty, 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, information technology, web site development, marketing, human resources, personnel recruiting, board recruiting, corporate governance, and risk management.

      Fees and other income for the year ended December 31, 2002, included fees of $15.0 million related to structuring and diligence, fees of $4.4 million related to transaction services provided to portfolio companies, and fees of $23.2 million related to management

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      BLX and Hillman are our most significant portfolio investments and together represented 15.6% of our total assets at December 31, 2002. Total interest and related portfolio income earned from these investments for the years ended December 31, 2002, 2001, and 2000, were $49.5 million, $39.6 million, and $2.7 million, respectively. In July 2002, we sold WyoTech Acquisition Corporation, which was a significant portfolio investment during 2002, 2001, and 2000. Total interest and related portfolio income earned on this investment for the years ended December 31, 2002, 2001, and 2000 was $3.6 million, $5.5 million, and $2.4 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, 2002, 2001, and 2000, are attributable to changes in the level of our borrowings under various notes payable and debentures and our revolving credit facility. Our borrowing activity and weighted average interest cost, including fees and closing costs, at and for the years ended December 31, 2002, 2001, and 2000, were as follows:

($ in millions)		2002				2001				2000
Total Outstanding Debt		$	998.5			$	1,020.8			$	786.6
Average Outstanding Debt		$	938.1			$	847.1			$	707.4
Weighted Average Interest Cost			6.9	%			7.0	%			8.3	%
BDC Asset Coverage*			270	%			245	%			245	%

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*	As a business development company, we are generally required to maintain a minimum ratio of 200% of total assets to total borrowings.

     Employee expenses include salaries and employee benefits. The change in employee expense reflects the effect of wage increases and the change in mix of employees given their area of responsibility and relevant experience level. Total employees were 105, 97, and 97 at December 31, 2002, 2001, and 2000, respectively.

      Administrative expenses include the leases for our headquarters in Washington, DC, and our regional offices, travel costs, stock record expenses, directors’ fees, legal and accounting fees, insurance premiums, and various other expenses. The increase in administrative expenses as compared to the year ended December 31, 2001, includes approximately $1.6 million from legal, consulting, and other fees, including costs incurred to defend against class action lawsuits alleging violations of securities laws and to respond to market activity in our stock. Administrative expenses also increased by approximately $0.9 million due to increased costs for corporate liability insurance, $0.7 million due to travel costs, including corporate aircraft depreciation, and $0.7 million due to outsourced technology assistance.

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      During the fourth quarter of 2002, we closed our office in Frankfurt, Germany, due to difficulty in finding attractive investment opportunities in Germany. In conjunction with this, we incurred employee and administrative costs of $0.5 million and $2.5 million, respectively, which reduced our net income for the year ended December 31, 2002, by a total of $3.0 million, or $0.03 per share.

      Realized Gains and Losses. Net realized gains result from the sale of equity securities associated with certain private finance investments, the sale of CMBS bonds, 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, 2002, 2001, and 2000, were as follows:

($ in millions)		2002				2001				2000
Realized Gains		$	95.5			$	10.1			$	28.6
Realized Losses			(50.6	)			(9.4	)			(13.1	)
Net Realized Gains		$	44.9			$	0.7			$	15.5

      Realized gains and losses for the year ended December 31, 2002, resulted from various private finance and commercial real estate finance transactions. 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). For the years ended December 31, 2002, 2001, and 2000, we reversed previously recorded unrealized appreciation totaling $78.8 million, $6.5 million, and $7.5 million, respectively, when gains were realized. When we exit an investment and realize a gain, we make an accounting entry to reverse any unrealized appreciation we had previously recorded to reflect the appreciated value of the investment.

      The most significant gain realized in 2002 was from the sale of WyoTech Acquisition Corporation. We acquired WyoTech in December of 1998 and owned 91% of the common equity of WyoTech. On July 1, 2002, WyoTech was sold for $84.4 million. At June 30, 2002, our investment had a cost basis of $16.4 million, which represented all of the debt ($12.6 million), preferred stock ($3.7 million) and 91% of the common equity capital ($0.1 million) of WyoTech. Our total proceeds from the sale of WyoTech, including the repayment of debt and preferred stock and the sale of our common equity ownership, were $77.2 million. We recognized a realized gain of $60.8 million on the transaction. The sale of WyoTech is subject to post-closing working capital adjustments, if any, and customary indemnification provisions.

      Realized losses for the year ended December 31, 2002, primarily resulted from transactions involving eleven 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),

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      Unrealized Gains and Losses. We determine the value of each investment in our portfolio on a quarterly basis, and changes in value result in unrealized gains or losses being recognized. At December 31, 2002, approximately 89% of our total assets represented portfolio investments recorded at fair value. 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. 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 company does not currently support the cost of our debt or equity investment. Conversely, 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 unrealized gains and losses.

      As a business development company, we invest in illiquid securities including debt and equity securities of primarily private companies and non-investment grade CMBS. 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 examination of, among other things, the underlying investment performance, financial condition, and market changing events that impact valuation.

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      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 monthly 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 accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America. 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 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 are determined based on various factors, including the enterprise value remaining for equity holders after the repayment of the portfolio company’s debt and other pertinent factors such as recent offers to purchase a portfolio company’s equity interest or other potential liquidity 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.

      Valuation Methodology — CMBS Bonds. CMBS bonds are carried at fair value, which is based on a discounted cash flow model, which utilizes prepayment and loss

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      For the portfolio, net unrealized gains (losses) for the years ended December 31, 2002, 2001, and 2000, were as follows:

			2002				2001				2000
($ in millions)
Unrealized gains:
	Unrealized gains		$	215.0			$	88.0			$	29.2
	Reversal of previously recorded unrealized depreciation associated with realized losses			49.0				8.9				12.0
Total unrealized gains			$	264.0			$	96.9			$	41.2
Unrealized losses:
	Unrealized losses		$	(185.8	)		$	(69.8	)		$	(18.8	)
	Reversal of previously recorded unrealized appreciation associated with realized gains			(78.8	)			(6.5	)			(7.5	)
Total unrealized losses			$	(264.6	)		$	(76.3	)		$	(26.3	)
Net unrealized gains (losses)			$	(0.6	)		$	20.6			$	14.9

      Unrealized gains associated with changes in the value of investments in our portfolio of $215.0 million for the year ended December 31, 2002, resulted from the recording of new or additional unrealized appreciation of $214.6 million and the reversal of previously recorded unrealized depreciation of $0.4 million. Unrealized appreciation for the year resulted primarily from the increase in the value of our investments in The Hillman Companies, Inc. ($87.8 million), Business Loan Express, Inc. ($19.9 million), CMBS bonds ($29.6 million, net of an unrealized loss of $8.2 million from a hedge related to the CMBS bonds), WyoTech Acquisition Corporation ($16.6 million), Blue Rhino Corporation ($16.6 million), CorrFlex Graphics LLC ($13.8 million), Kirkland’s, Inc. ($5.8 million), CyberRep ($4.9 million), Morton Grove Pharmaceuticals, Inc. ($4.4 million), and Oriental Trading Company, Inc. ($4.3 million).

      The most significant components of unrealized gains resulted from our investments in Hillman, BLX, and CMBS bonds. The following is a simplified summary of the methodology that we used to determine the fair value of these investments.

      The Hillman Companies, Inc. Hillman achieved several milestones in 2002, including the completion of two acquisitions, the reduction of excess corporate overhead, and significant improvements to its operating structure. In performing our valuation

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      We believe the current enterprise value for Hillman is approximately $409.5 million, or 7.0 times 2002 normalized EBITDAM of $58.5 million. The multiple was determined by obtaining a range of multiples representing the multiple of enterprise value to EBITDA for comparable public companies and the multiple of enterprise value to EBITDA for acquisition transactions involving companies in Hillman’s peer group. From this market comparable analysis, we selected a 7.0 times multiple for our valuation. Using an enterprise value of $409.5 million, the value of our equity investment in Hillman is approximately $138.4 million, or $87.8 million greater than our cost basis of $50.6 million.

      Business Loan Express, Inc. To determine the value of our investment in BLX at December 31, 2002, we performed four separate valuation analyses to determine its enterprise value: (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. The range of enterprise values resulting from these analyses was between $366 million and $504 million. We used an enterprise value of $373 million to value our equity investment in BLX. This enterprise value is based on a pro forma equity value of 7.4 times trailing pro forma BLX net income adjusted for certain capital structure changes that would likely occur should the company be sold. Given an enterprise value of $373 million, the equity value for our common stock investment has a value of $140.0 million. The common equity value of $140.0 million at December 31, 2002, increased by $19.9 million over the equity value of $120.1 million at December 31, 2001, resulting in an unrealized gain of $19.9 million during 2002. Our investment at fair value of $256.8 million at December 31, 2002, represents a multiple of 1.7 times our share of BLX’s junior capital at December 31, 2002.

      CMBS Bonds. We recorded a net unrealized gain on our CMBS bond portfolio of $37.8 million for 2002. We determined the fair value of our CMBS bond portfolio using a discounted cash flow model based upon (i) the current performance of the underlying collateral loans, which utilizes prepayment and loss assumptions based upon historical and projected experience, economic factors and the characteristics of the underlying cash flow, and (ii) current market yields for comparable CMBS bonds, based on comparable Treasury rates and market spreads. In addition, we recorded an unrealized loss of $8.2 million from a hedge related to the CMBS bonds. For 2002, the net unrealized gain on the CMBS bond portfolio, net of the unrealized loss from the related hedge, was $29.6 million.

      Given that market yields fluctuate, it is possible that there may be future adjustments to the fair value of the CMBS bonds. As a result, we have not classified the appreciated CMBS bonds as Grade 1 assets at December 31, 2002, since they may not result in any future capital gain. Therefore, CMBS bonds remain in Grade 2.

      Unrealized losses associated with the changes in the value of investments in our portfolio totaled $185.8 million for the year ended December 31, 2002, and resulted from the recording of new or additional unrealized depreciation of $178.4 million and the reversal of previously recorded unrealized appreciation of $7.4 million.

      We experienced a significant level of new or additional unrealized depreciation in the portfolio during 2002, largely due to a struggling U.S. economy and continued deterioration

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OTHER MATTERS

      Per Share Amounts. All per share amounts included in 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 103.6 million, 93.0 million, and 73.5 million for the years ended December 31, 2002, 2001, and 2000, 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. As long as we qualify as a regulated investment company, we are not taxed on our investment company taxable income or realized capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to shareholders on a timely basis. Annual tax distributions generally differ from net income for the fiscal year due to temporary and permanent timing differences in the recognition of income and expenses, returns of capital and net unrealized appreciation or depreciation, which are not included in taxable income.

      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 investment diversification requirements as defined in the Internal Revenue Code; and (4) distribute annually to shareholders at least 90% of our investment company taxable income as defined in the Internal Revenue 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.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Equivalents

      At December 31, 2002, we had $11.2 million in cash and cash equivalents. We invest otherwise uninvested cash in U.S. government- or agency-issued or guaranteed securities that are backed by the full faith and credit of the United States, or in high quality, short-term repurchase agreements fully collateralized by such securities. Our objective is to manage to a low cash balance and fund new originations with our revolving line of credit.

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Debt and Other Commitments

      We had outstanding debt at December 31, 2002, as follows:

												Annual				Annual Portfolio
				Facility				Amount				Interest				Return to Cover
				Amount				Outstanding				Cost(1)				Interest Payments(3)
($ in millions)
Notes payable and debentures:
	Unsecured long-term notes			$	694.0			$	694.0				7.7	%			1.9	%
	Small Business Administration debentures				101.8				94.5				8.2	%			0.3	%
	Overseas Private Investment Corporation loan				5.7				5.7				6.6	%			0.0	%
		Total notes payable and debentures		$	801.5			$	794.2				7.8	%			2.2	%
Revolving line of credit					527.5				204.3				3.7	%(2)			0.3	%
		Total debt		$	1,329.0			$	998.5				6.9	%			2.5	%

(1)	The annual interest cost on notes payable and debentures includes the cost of commitment fees and other facility fees that are recognized into interest expense over the contractual life of the respective borrowings.
(2)	The current interest rate payable on the revolving line of credit was 2.7% at December 31, 2002, which excludes the annual cost of commitment fees and other facility fees of $2.0 million.
(3)	The annual portfolio return to cover interest payments is calculated as the December 31, 2002 annualized cost of debt per class of financing divided by total assets at December 31, 2002.

     Unsecured Long-Term Notes. 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 2003. The notes require payment of interest only semi-annually, and all principal is due upon maturity.

      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. Under the small business investment company program, we may borrow up to $113.4 million from the Small Business Administration. At December 31, 2002, the Small Business Administration has a commitment to lend up to an additional $7.3 million above the current amount outstanding. The commitment expires on September 30, 2005.

      Revolving Line of Credit. As of December 31, 2002, we have a $527.5 million unsecured revolving line of credit that expires in August 2003, with the right to extend the maturity for one additional year at our sole option under substantially similar terms. This facility was increased by $30.0 million during 2002 from $497.5 million at December 31, 2001, and may be further expanded up to $600 million. As of December 31, 2002, $318.0 million remains unused and available, net of amounts committed for standby letters of credit of $5.3 million issued under the credit facility. The credit facility bears interest at a rate equal to (i) the one-month LIBOR plus 1.25%, (ii) the Bank of America, N.A. prime rate, or (iii) the Federal Funds rate plus 0.50% at our option. The credit facility requires monthly payments of interest, and all principal is due upon maturity.

      We have various financial and operating covenants required by the revolving line of credit and the 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, 2002, we were in compliance with these covenants.

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      Auction Rate Reset Note. We repaid a $75.0 million Auction Rate Reset Note Series A in December 2002. We have entered into an agreement with the placement agent of this note to serve as the placement agent on a future offering of $75.0 million of debt, equity or other securities in one or more public or private transactions. If we do not conduct a capital raise, we will incur additional expenses of approximately $3.2 million.

      The following table shows our significant contractual obligations as of December 31, 2002.

							Payments Due By Year
																											After
($ in millions)			Total				2003				2004				2005				2006				2007				2007
Notes payable and debentures:
	Unsecured long-term notes		$	694.0			$	140.0			$	214.0			$	165.0			$	175.0			$	—			$	—
	Small Business Administration debentures			94.5				—				7.0				14.0				—				—				73.5
	Overseas Private Investment Corporation loan			5.7				—				—				—				5.7				—				—
Revolving line of credit(1)				204.3				—				204.3				—				—				—				—
Operating Leases				21.0				2.6				2.7				2.7				2.6				2.5				7.9
Total contractual obligations			$	1,019.5			$	142.6			$	428.0			$	181.7			$	183.3			$	2.5			$	81.4

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(1)

The revolving line of credit expires in August 2003 and may be extended under substantially similar terms for one additional year at our sole option. We assume that we would exercise our option to extend the revolving line of credit resulting in an assumed maturity of August 2004. At December 31, 2002, $318.0 million remains unused and available, net of amounts committed for standby letters of credit of $5.3 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, 2002.

						Amount of Commitment Expiration Per Year
																										After
($ in millions)		Total				2003				2004				2005				2006				2007				2007
Standby letters of credit		$	11.3			$	—			$	5.3			$	—			$	—			$	—			$	6.0
Guarantees			54.6				1.7				52.4				0.3				0.1				0.1				—
Total commitments		$	65.9			$	1.7			$	57.7			$	0.3			$	0.1			$	0.1			$	6.0

Equity Capital and Dividends

      Because we are a regulated investment company, we distribute our income and require external capital for growth. Because we are a business development company, we are limited in the amount of debt capital we may use to fund our growth, since we are generally required to maintain a minimum ratio of 200% of total assets to total borrowings, or approximately a 1 to 1 debt to equity ratio.

      To support our growth during the year ended December 31, 2002, we raised $172.8 million in new equity capital, including $86.5 million raised through a non-transferable rights offering. During 2001, we raised $286.9 million in new equity capital through the sale of shares from our shelf registration statement. We issue equity from time to time when we have attractive investment opportunities. In addition, we raised $6.3 million in new equity capital through the issuance of shares through our dividend reinvestment plan during both of the years ended December 31, 2002 and 2001. During

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      Our board of directors reviews the dividend rate quarterly, and may adjust the quarterly dividend throughout the year. For the first, second, third, and fourth quarters of 2002, the board of directors declared a dividend of $0.53, $0.55, $0.56, and $0.56 per common share, respectively. An extra cash dividend of $0.03 per share was declared during 2002 and was paid to shareholders on January 9, 2003. For the first quarter of 2003, the board of directors has declared a dividend of $0.57 per common share. Dividends are paid based on our taxable income, which includes our taxable interest and fee income as well as taxable net realized capital gains. Our board of directors evaluates whether to retain or distribute capital gains on an annual basis. Our dividend policy allows us to continue to distribute capital gains, but will also allow us to retain gains to support future growth.

      Liquidity and Capital Resources. We plan to maintain a strategy of financing our business and related debt maturities with cash from operations, through borrowings under short- or long-term credit facilities or other debt securities, through asset sales, or through the sale or issuance of new equity capital. We currently anticipate an increased level of new investment activity during 2003 given the level of prospective investments currently under review. Although there can be no assurance that we will secure these new investments, we plan to raise new debt and equity capital as appropriate to fund investment growth prospectively.

      Dividends paid to shareholders for the years ended December 31, 2002 and 2001 were $229.9 million and $186.2 million, respectively. Cash flow from operations before new investments has historically been sufficient to finance our operations.

      We maintain a matched-funding philosophy that focuses on matching the estimated maturities of our loan and investment portfolio to the estimated maturities of our borrowings. We use our short-term credit facilities as a means to bridge to long-term financing, which may or may not result in temporary differences in the matching of estimated maturities. We evaluate our interest rate exposure on an ongoing basis. 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, 2002, our debt to equity ratio was 0.65 to 1 and our weighted average cost of funds was 6.9%. Availability on the revolving line of credit, net of amounts committed for standby letters of credit issued under the line of credit facility, was $318.0 million on December 31, 2002. We believe that we have access to capital sufficient to fund our ongoing investment and operating activities.

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

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        Valuation of Portfolio Investments. As a business development company, we invest in illiquid securities including debt and equity securities of primarily private companies and non-investment grade CMBS. 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 company does not currently support the cost of our debt or equity investments. Conversely, 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 are determined using quoted market prices discounted for restrictions on resale.

        Loans and Debt Securities. For loans and debt securities, fair value generally approximates cost unless the borrower’s enterprise value or 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 classified as Grade 4 or Grade 5 assets 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 if such companies are in need of additional capital. Loan origination fees, original issue discount, and market discount are capitalized and then amortized into interest income using the effective interest method. Prepayment premiums are recorded on loans when received.

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

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        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’s securities or other liquidation events. The determined fair 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 upon 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”). CMBS bonds are carried at fair value, which is based upon a discounted cash flow model that utilizes prepayment and loss assumptions based upon historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable market yields for similar CMBS bonds. Our assumption with regard to discount rate for determining fair value is based on the yield of comparable securities. 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 estimates of future credit losses, actual losses incurred, or actual and estimated prepayment speeds. 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. We recognize unrealized appreciation or depreciation on our CMBS bonds as comparable yields in the market change and based on changes in estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool.

      Residual Interest. We value our residual interest from a previous securitization and recognize income using the same accounting policies used for the CMBS bonds. The residual interest is carried at fair value based on discounted estimated future cash flows. We recognize income from the residual interest using the effective interest method. At each reporting date, the effective yield is recalculated and used to recognize income until the next reporting date.

      Net Realized and Unrealized Gains or Losses. Realized gains or losses are measured by the difference between the net proceeds from the sale and the cost basis of the investment without regard to unrealized gains or losses previously recognized, and include investments charged off during the year, net of recoveries. Unrealized gains or losses reflect the change in portfolio investment values during the reporting period.

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

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SENIOR SECURITIES

      Information about our senior securities is shown in the following tables as of the fiscal year ended December 31, unless otherwise noted. The “—” indicates information which the SEC expressly does not require to be disclosed for certain types of senior securities.

		Total Amount
		Outstanding								Involuntary
		Exclusive of				Asset				Liquidating				Average
		Treasury				Coverage				Preference				Market Value
Class and Year		Securities(1)				Per Unit(2)				Per Unit(3)				Per Unit(4)
Unsecured Long-term Notes Payable
1993		$	0			$	0			$	—				N/A
1994			0				0				—				N/A
1995			0				0				—				N/A
1996			0				0				—				N/A
1997			0				0				—				N/A
1998			180,000,000				2,734				—				N/A
1999			419,000,000				2,283				—				N/A
2000			544,000,000				2,445				—				N/A
2001			694,000,000				2,453				—				N/A
2002			694,000,000				2,704				—				N/A
Small Business Administration Debentures(5)
1993		$	49,800,000			$	6,013			$	—				N/A
1994			54,800,000				3,695				—				N/A
1995			61,300,000				2,868				—				N/A
1996			61,300,000				2,485				—				N/A
1997			54,300,000				2,215				—				N/A
1998			47,650,000				2,734				—				N/A
1999			62,650,000				2,283				—				N/A
2000			78,350,000				2,445				—				N/A
2001			94,500,000				2,453				—				N/A
2002			94,500,000				2,704				—				N/A
Overseas Private Investment   Corporation Loan
1993		$	0			$	0			$	—				N/A
1994			0				0				—				N/A
1995			0				0				—				N/A
1996			8,700,000				2,485				—				N/A
1997			8,700,000				2,215				—				N/A
1998			5,700,000				2,734				—				N/A
1999			5,700,000				2,283				—				N/A
2000			5,700,000				2,445				—				N/A
2001			5,700,000				2,453				—				N/A
2002			5,700,000				2,704				—				N/A

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		Total Amount
		Outstanding								Involuntary
		Exclusive of				Asset				Liquidating				Average
		Treasury				Coverage				Preference				Market Value
Class and Year		Securities(1)				Per Unit(2)				Per Unit(3)				Per Unit(4)
Revolving Lines of Credit
1993		$	0			$	0			$	—				N/A
1994			32,226,000				3,695				—				N/A
1995			20,414,000				2,868				—				N/A
1996			45,099,000				2,485				—				N/A
1997			38,842,000				2,215				—				N/A
1998			95,000,000				2,734				—				N/A
1999			82,000,000				2,283				—				N/A
2000			82,000,000				2,445				—				N/A
2001			144,750,000				2,453				—				N/A
2002			204,250,000				2,704				—				N/A
Auction Rate Reset Note
1993		$	0			$	0			$	—				N/A
1994			0				0				—				N/A
1995			0				0				—				N/A
1996			0				0				—				N/A
1997			0				0				—				N/A
1998			0				0				—				N/A
1999			0				0				—				N/A
2000			76,598,000				2,445				—				N/A
2001			81,856,000				2,453				—				N/A
2002			0				0				—				N/A
Master Repurchase Agreement and Master Loan and Security Agreement
1993		$	0			$	0			$	—				N/A
1994			23,210,000				3,695				—				N/A
1995			0				0				—				N/A
1996			85,775,000				2,485				—				N/A
1997			225,821,000				2,215				—				N/A
1998			6,000,000				2,734				—				N/A
1999			23,500,000				2,283				—				N/A
2000			0				0				—				N/A
2001			0				0				—				N/A
2002			0				0				—				N/A

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		Total Amount
		Outstanding								Involuntary
		Exclusive of				Asset				Liquidating				Average
		Treasury				Coverage				Preference				Market Value
Class and Year		Securities(1)				Per Unit(2)				Per Unit(3)				Per Unit(4)
Senior Note Payable(6)
1993		$	20,000,000			$	6,013			$	—				N/A
1994			20,000,000				3,695				—				N/A
1995			20,000,000				2,868				—				N/A
1996			20,000,000				2,485				—				N/A
1997			20,000,000				2,215				—				N/A
1998			0				0				—				N/A
1999			0				0				—				N/A
2000			0				0				—				N/A
2001			0				0				—				N/A
2002			0				0				—				N/A
Bonds Payable
1993		$	0			$	0			$	—				N/A
1994			0				0				—				N/A
1995			98,625,000				2,868				—				N/A
1996			54,123,000				2,485				—				N/A
1997			0				0				—				N/A
1998			0				0				—				N/A
1999			0				0				—				N/A
2000			0				0				—				N/A
2001			0				0				—				N/A
2002			0				0				—				N/A
Redeemable Cumulative   Preferred Stock(5)
1993		$	1,000,000			$	546			$	100				N/A
1994			1,000,000				351				100				N/A
1995			1,000,000				277				100				N/A
1996			1,000,000				242				100				N/A
1997			1,000,000				217				100				N/A
1998			1,000,000				267				100				N/A
1999			1,000,000				225				100				N/A
2000			1,000,000				242				100				N/A
2001			1,000,000				244				100				N/A
2002			1,000,000				268				100				N/A
Non-Redeemable Cumulative Preferred Stock(5)
1993		$	6,000,000			$	546			$	100				N/A
1994			6,000,000				351				100				N/A
1995			6,000,000				277				100				N/A
1996			6,000,000				242				100				N/A
1997			6,000,000				217				100				N/A
1998			6,000,000				267				100				N/A
1999			6,000,000				225				100				N/A
2000			6,000,000				242				100				N/A
2001			6,000,000				244				100				N/A
2002			6,000,000				268				100				N/A

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(1)	Total amount of each class of senior securities outstanding at the end of the period presented.
(2)	The asset coverage ratio for a class of senior securities representing indebtedness is calculated as our consolidated total assets, less all liabilities and indebtedness not represented by senior securities, divided by senior securities representing indebtedness. This asset coverage ratio is multiplied by $1,000 to determine the Asset Coverage Per Unit. The asset coverage ratio for a class of senior securities that is preferred stock is calculated as our consolidated total assets, less all liabilities and indebtedness not represented by senior securities, divided by senior securities representing indebtedness, plus the involuntary liquidation preference of the preferred stock (see footnote 3). The Asset Coverage Per Unit for preferred stock is expressed in terms of dollar amounts per share.
(3)	The amount to which such class of senior security would be entitled upon the involuntary liquidation of the issuer in preference to any security junior to it.
(4)	Not applicable, as senior securities are not registered for public trading.
(5)	Issued by our small business investment company subsidiary to the Small Business Administration. These categories of senior securities are not subject to the asset coverage requirements of the 1940 Act. See “Certain Government Regulations — Small Business Administration Regulations.”
(6)	We were the obligor on $15 million of the senior notes. Our small business investment company subsidiary was the obligor on the remaining $5 million, which is not subject to the asset coverage requirements of the 1940 Act.

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BUSINESS

General

      As a business development company, we provide long-term debt and equity investment capital to support the expansion of companies in a variety of industries. We generally invest in illiquid securities through privately negotiated transactions. We generally invest in private middle market companies though, from time to time, we may invest in public companies that lack access to public capital or whose securities may not be marginable. We have been investing in businesses for over 40 years and have financed thousands of companies nationwide. Today, our investment and lending activity is generally focused in two areas:

	•	Private finance and
	•	Commercial real estate finance, primarily the investment in non-investment grade commercial mortgage-backed securities.

      Our investment portfolio consists primarily of long-term unsecured loans with or without equity features, equity investments in companies, which may or may not constitute a controlling equity interest, non-investment grade commercial mortgage-backed securities, preferred shares in collateralized debt obligations, and commercial mortgage loans. At December 31, 2002, our investment portfolio totaled $2.5 billion at value. Our investment objective is to achieve current income and capital gains.

Corporate History and Offices

      Allied Capital Corporation was formed in 1958. On December 31, 1997, Allied Capital Corporation, Allied Capital Corporation II, Allied Capital Commercial Corporation and Allied Capital Advisers, Inc. merged with and into Allied Capital Lending Corporation in a tax-free stock-for-stock exchange. Immediately following the merger, Allied Capital Lending Corporation changed its name to “Allied Capital Corporation.”

      We are a Maryland corporation and a closed-end management investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940. We are a registered investment adviser. We have a subsidiary that has also elected to be regulated as a BDC, Allied Investment Corporation, which is licensed under the Small Business Investment Act of 1958 as a Small Business Investment Company. See “Certain Government Regulations” below for further information about small business investment company regulation.

      In addition, we have a real estate investment trust subsidiary, Allied Capital REIT, Inc., and several subsidiaries which are single-member limited liability companies established primarily to hold real estate properties. We have also established a subsidiary, A.C. Corporation (“AC Corp”) that provides diligence and structuring services on private finance and commercial real estate transactions, as well as structuring, transaction, management and advisory services to Allied Capital, our portfolio companies and other third parties.

      Our executive offices are located at 1919 Pennsylvania Avenue, NW, Washington, DC 20006 and our telephone number is (202) 331-1112. In addition, we have regional offices in New York and Chicago.

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Private Finance

      We participate in the private equity business by providing privately negotiated long-term debt and equity investment capital. Our private finance investment activity is generally focused on providing junior capital in the form of subordinated debt with or without equity features, such as warrants or options, often referred to as mezzanine financing. In certain situations, we may also take a controlling equity position in a company. Our private financing is generally used to fund growth, buyouts, acquisitions, recapitalizations, note purchases, and bridge financings. We generally invest in private companies though, from time to time, we may invest in public companies that lack access to public capital or whose securities may not be marginable.

      At December 31, 2002, 66% of the private finance portfolio consisted of loans and debt securities and 34% consisted of equity securities.

      Our private finance portfolio includes investments in a wide variety of industries, including non-durable consumer products, business services, financial services, light industrial products, healthcare services, retail, telecommunications, education and broadcasting. The industry and geographic compositions of the private finance portfolio at value at December 31, 2002 and 2001, were as follows:

			2002				2001
Industry
Consumer products				34	%			28	%
Business services				26				22
Financial services				16				15
Industrial products				9				10
Healthcare				5				3
Retail				4				5
Telecommunications				2				4
Broadcasting & cable				1				4
Education				1				5
Other				2				4
	Total			100	%			100	%
Geographic Region
Mid-Atlantic				45	%			43	%
Midwest				16				17
Southeast				16				14
West				15				19
Northeast				7				5
International				1				2
	Total			100	%			100	%

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      Market and Competition. Capital providers for the finance of private companies can be generally categorized as shown in the diagram below:

Capital Provider

Banks

Commercial Finance Companies

Private Placement/ High Yield

Private Mezzanine Funds

Allied Capital

Private Equity Funds

Primary Business Focus

Senior, short- term debt

Asset-based lending

Large credits (private > $50 mm) (public > $150 mm)

Unsecured long- term debt with warrants Preferred and common equity

Unsecured long- term debt with warrants Preferred and common equity

Equity

Typical Pricing Spectrum*

LIBOR+

[graphic of arrow stretching between “LIBOR+” and “25%+”]

25%+

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*	Based on our market experience.

     Banks are primarily focused on providing senior secured and unsecured short-term debt. They typically do not provide meaningful long-term unsecured loans. Commercial finance companies are primarily focused on providing senior secured long-term debt. The private placement and high-yield debt markets are focused primarily on very large financing transactions, typically in excess of the financings we do. We typically do not compete with banks, commercial finance companies, or the private placement/high yield market. Instead, we compete directly with the private mezzanine sector of the private capital market. Private mezzanine funds are also focused on providing unsecured long-term debt to private companies for the types of transactions discussed above. We believe that we have key structural and operational advantages when compared to private mezzanine funds.

      Many private mezzanine funds operate with a more expensive cost structure than ours because of carried interest fees paid to the management of the funds. In addition, our access to the public equity markets generally gives us a lower cost of capital than that of private mezzanine funds. Our lower cost of capital may give us a pricing advantage when competing for new investments. In addition, the perpetual nature of our corporate structure enables us to be a better long-term partner for our portfolio companies than a traditional mezzanine fund, which typically has a limited life.

      Over our 42-year history, we have developed and maintained relationships with intermediaries including investment banks, financial services companies, and private mezzanine and equity sponsors, through which we source investment opportunities. Through these relationships, especially those with equity sponsors, we have been able to strengthen our position as a long-term investor. For the transactions in which we have provided debt capital, an equity sponsor provides a reliable source of additional equity capital if the portfolio company requires additional financing. Private equity sponsors also assist us in confirming our own due diligence findings when assessing a new investment opportunity, and they provide assistance and leadership to the portfolio company’s management team throughout our investment period.

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      Investment Criteria. When assessing a prospective investment, we look for companies with certain target characteristics, which may or may not be present in the companies in which we invest. Our target characteristics generally include the following:

	•	Management teams with meaningful equity ownership
	•	Dominant or defensible market position
	•	High return on invested capital
	•	Revenues of $50 million to $500 million
	•	Stable operating margins
	•	EBITDA (or Earnings Before Interest, Taxes, Depreciation and Amortization) of at least $5 million
	•	Solid cash flow margins
	•	Sound balance sheets

      We generally target and do not target the following industries, though we will consider investments in any industry if the prospective company demonstrates unique characteristics that make it an attractive investment opportunity:

Industries Targeted				Industries Not Targeted
Less Cyclical/Cash Flow Intensive/				Cyclical/Capital Intensive/
High Return on Capital				Low Return on Capital
Consumer products Business services Financial services Light industrial products Broadcasting				Heavy equipment Natural resources Commodity retail Low value-add distribution Agriculture Transportation

      Investment Structure. Once we have determined that a prospective portfolio company is suitable for investment, we work with the management and the other capital providers, including senior, junior, and equity capital providers, to structure a “deal.” We negotiate among these parties to agree on how our investment is expected to perform relative to the other capital in the portfolio company’s capital structure. Generally, our private finance portfolio companies seek a component of senior capital above us and an equity piece below us.

      Our private finance mezzanine investments are generally structured as unsecured, subordinated loans that carry a relatively high contractual fixed interest rate generally in excess of 12%, to provide interest income. At December 31, 2002, approximately 95% of the loans and debt securities in the private finance portfolio have fixed rates of interest. The loans have interest-only payments in the early years and payments of both principal and interest in the later years, with maturities of five to ten years, although debt maturities and principal amortization schedules vary. Such payments are generally made to us quarterly.

      Our mezzanine debt instruments are tailored to the facts and circumstances of the deal. The specific structure is negotiated over a period of several months and is designed to

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      We exit our private finance investments generally when a liquidity event takes place, such as the sale, recapitalization, or initial public offering of such portfolio company. Generally, our warrants expire five years after the related debt is repaid. The warrants typically include registration rights, which allow us to sell the securities if the portfolio company completes a public offering. Most of the gains we realize from our warrant portfolio arise as a result of the sale of the portfolio company to another business or through a recapitalization. Historically, we have not been dependent on the public equity markets for the sale of our warrant positions.

      We may also acquire preferred or common equity in a company as a part of our private finance investing activities, particularly when we see a unique opportunity to profit from the growth of a company. Preferred equity investments may be structured with a dividend yield, which would provide us with a current return. With respect to preferred or common equity investments, we generally target an investment return of 25% to 40%.

      In addition to our private finance mezzanine investment activities, we may acquire more than 50% of the common stock of a company in a control buyout transaction. In addition to our common equity investment, we may also provide additional capital to the controlled portfolio company in the form of senior loans, subordinated debt or preferred stock. The types of companies that we would acquire through a control buyout transaction are generally the same types of companies that we would invest in through our other private finance investing activities. In particular, we may see opportunities to acquire illiquid public companies and take them private. We intend to be selective about the companies in which we acquire a controlling interest to ensure that we maintain a diversified portfolio.

      We generally structure our control investments such that we earn a current return through a combination of interest income on our senior loans and subordinated debt, dividends on our preferred and common stock, and management or transaction services fees to compensate us for the managerial assistance that we provide to a controlled portfolio company. For these types of investments, we generally target an overall investment return of 25% to 40%.

      At December 31, 2002, our most significant investments acquired through control buyout transactions were Business Loan Express, Inc. (BLX) and The Hillman Companies, Inc.

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      At December 31, 2002, we had an investment at value totaling $256.8 million in BLX, a small business lender that participates in the U.S. Small Business Administration 7(a) Guaranteed Loan Program. At December 31, 2002, we owned 94.9% of BLX’s common stock. Our common stock ownership is subject to dilution by management options. As the controlling shareholder of BLX, we have provided an unconditional guaranty to the BLX credit facility lenders in an amount up to 50% of the total obligations (consisting of principal, accrued interest and other fees) on BLX’s three-year unsecured $124.0 million revolving credit facility that matures in March 2004. The amount guaranteed by us at December 31, 2002 was $51.6 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, 2002. We have also provided two standby letters of credit in connection with two term securitization transactions completed by BLX totaling $10.6 million.

      BLX is the nation’s second largest non-bank government guaranteed 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 preferred lender as designated by the SBA in 68 markets across the United States, and originates, sells, and services small business loans. In addition to the 7(a) Guaranteed Loan Program, BLX originates conventional small business loans and originates loans under the USDA Business and Industry Guaranteed Loan Program. In February 2003, BLX completed a corporate reorganization to a limited liability company. BLX has offices across the United States and is headquartered in New York, New York.

      At December 31, 2002, we had an investment in The Hillman Companies, Inc. totaling $180.5 million at value. At December 31, 2002, we owned 96.8% of Hillman’s common stock. Our common stock ownership is subject to dilution by management options. Hillman is a leading manufacturer of key making equipment and distributor of key blanks, fasteners, signage, and other small hardware components and operates in multiple channels of the retail marketplace such as hardware stores, national and regional home centers, and mass merchants. Hillman has certain patent-protected products, including key duplication technology, that is important to its business. Hillman’s primary operations are located in Cincinnati, Ohio.

      We fund new investments using cash, through the issuance of our common equity, 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 also opt to reinvest accrued interest receivable in a new debt or equity security, in lieu of receiving such interest in cash and providing a subsequent investment. When we acquire a controlling interest in a company, we may have the opportunity to acquire the company’s equity with our common stock. The issuance of our stock as consideration may provide us with the benefit of raising equity without having to access the public markets in an underwritten offering, including the added benefit of the elimination of any underwriter commissions.

      As a business development company, we are required to make significant managerial assistance available to the companies in our investment portfolio. In addition to the interest and dividends received from our private finance investments, we will often generate additional fee income for the structuring, diligence, transaction and management services and guarantees we provide to our portfolio companies.

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Commercial Real Estate Finance

      Our primary commercial real estate investment activity is the investment in non-investment grade commercial mortgage-backed securities, which we refer to as CMBS. As an investor, we believe that CMBS bonds have attractive risk/return characteristics. The CMBS bonds in which we invest are non-investment grade, which means that nationally recognized statistical rating organizations rate them below the top four investment-grade rating categories (i.e., “AAA” through “BBB”), and are sometimes referred to as “junk bonds.” Unlike most “junk bonds,” which are typically unsecured debt instruments, the non-investment grade CMBS bonds in which we invest are secured by an underlying collateral pool of commercial mortgage loans, which are, in turn, secured by commercial real estate. The underlying collateral for our CMBS bonds consists of senior mortgage loans on commercial real estate properties where the loans, on average, were underwritten to achieve a loan to value ratio of approximately 70%. We generally invest in CMBS bonds on the initial issuance of the CMBS bond offering, and are able to underwrite and negotiate to acquire the securities at a significant discount from their face amount, generally resulting in an estimated yield to maturity ranging from 13% to 16%. We find the yields for CMBS bonds attractive given their collateral protection.

      We believe this risk/return dynamic exists in the market because there are significant barriers to entry for a non-investment grade CMBS investor. First, non-investment grade CMBS are long-term investments and require long-term investment capital. Our capital structure, which is in excess of 50% equity capital, is well suited for this asset class. Second, when we purchase CMBS bonds in an initial issuance, we re-underwrite the mortgage loans in the underlying collateral pool, and we meet with issuers to discuss the nature and type of loans we will accept into the pool. We have significant commercial mortgage loan underwriting expertise, both in terms of the number of professionals we employ and the depth of their commercial real estate experience. Access to this type of expertise is another barrier to entry into this market.

      As a non-investment grade CMBS investor, we recognize that non-investment grade bonds have a higher degree of risk than do investment-grade bonds. Non-investment grade securities are considered speculative, and their capacity to pay principal and interest in accordance with the terms of their issue is not ensured. They tend to be less liquid, may have a higher risk of default, and may be more difficult to value. We invest in non-investment grade CMBS bonds represented by the “BB+” to non-rated tranches of a CMBS issuance. The non-investment grade CMBS bonds in which we invest are junior in priority for payment of principal and interest to the more senior tranches of the related CMBS bond issuance. Cash flow from the underlying mortgages is allocated first to the senior tranches, with the most senior tranches having a priority right to the cash flow. Then, any remaining cash flow is allocated, among the other tranches in order of their relative seniority. To the extent there are defaults and unrecoverable losses on the underlying mortgages resulting in reduced cash flows, our most subordinate tranch will bear this loss first. At December 31, 2002, our CMBS bonds were subordinate to 91% to 97% of the tranches of bonds issued in various CMBS transactions.

      To mitigate the risks associated with a CMBS investment discussed above, we perform extensive due diligence prior to each investment in CMBS. The underwriting procedures and criteria used to underwrite each of the commercial mortgage loans in each collateral pool are described in detail below. We will only invest in CMBS when we believe, as a result of our underwriting procedures, that the underlying mortgage pool adequately secures our position. At December 31, 2002, the underlying pools of mortgage

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      The property types and the geographic composition of the underlying mortgage loans securing the CMBS bonds, calculated using the outstanding principal balance, at December 31, 2002 and 2001, were as follows:

			2002				2001
Property Type
Retail				32	%			31	%
Housing				27				27
Office				21				22
Industrial Real Estate				7				6
Hospitality				6				7
Other				7				7
	Total			100	%			100	%
Geographic Region
West				31	%			32	%
Mid-Atlantic				25				24
Midwest				22				21
Southeast				17				17
Northeast				5				6
	Total			100	%			100	%

      In addition to our CMBS bond investments, we have invested in the preferred shares of four collateralized debt obligations, or CDOs, secured by investment grade unsecured debt issued by various real estate investment trusts, or REITs, and CMBS bonds. The preferred shares are junior in priority for payment of principal and interest to the more senior tranches of debt issued by the CDOs. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, the preferred shares will bear this loss first. At December 31, 2002, our preferred shares in the CDOs were subordinate to approximately 96% of the more senior tranches of debt issued by the CDOs. The yield on the CDOs at December 31, 2002 was 17.2%.

      Our CMBS investing activity complements our private finance activity because it provides a steady stream of recurring interest income. In addition, given the depth of our commercial real estate experience and the due diligence that we perform prior to an investment in CMBS, we have from time to time received structuring and diligence fees upon the investment in CMBS bonds. These fees are separately negotiated for each transaction. In order to maintain a balanced investment portfolio, we expect that our investment in CMBS will not exceed 25% of our total assets.

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Investment Sourcing

      We maintain a network of relationships with investors, lenders and intermediaries including:

	•	private mezzanine and equity investors;
	•	investment banks;
	•	business brokers;
	•	merger and acquisition advisors;
	•	financial services companies; and
	•	banks, law firms and accountants.

      We believe that our experience and reputation provide a competitive advantage in originating new investments. We have established an extensive network of investment referral relationships over our history.

Investment Approval and Underwriting Procedures

      In assessing new investment opportunities, we follow an institutionalized process which includes a due diligence process and a centralized credit and investment approval process requiring committee review, all of which are described below.

      Private Finance. The typical private finance transaction requires two to four months of diligence and structuring before funding occurs. The due diligence process is significantly longer for those transactions in which we take a control position or substantial equity stake in the company. The key steps in our private finance investment process are as follows:

	•	Initial investment screening;
	•	Presentation of investment to investment professionals at weekly meeting;
	•	Initial approval of the investment by the investment committee;
	•	Due diligence completed and investment structured;
	•	Independent internal peer review of the investment completed;
	•	Final approval of the investment by the investment committee;
	•	Approval of the investment by the executive committee of the board of directors (for all investments greater than $10 million); and
	•	Investment is funded.

      In a typical private financing, we thoroughly review, analyze, and substantiate, through due diligence, the business plan and operations of the potential portfolio company. We perform financial due diligence, often with the assistance of an accounting firm; perform operational due diligence, often with the assistance of an industry consultant; study the industry and competitive landscape; and conduct numerous reference checks with current and former employees, customers, suppliers, and competitors.

      Private finance transactions are approved by an investment committee consisting of our most senior officers and chaired by our Chairman and Chief Executive Officer, William L. Walton. The private finance approval process benefits from the investment committee members and our other investment professionals who have significant

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      CMBS. We receive extensive packages of information regarding the mortgage loans comprising a CMBS pool. We work with the issuer, the investment bank, and the rating agencies in performing our diligence on a CMBS investment. The typical CMBS investment takes between two to three months to complete because of the breadth and depth of our diligence procedures. The key steps in our CMBS investment process are as follows:

	•	Review initial loan collateral pool data;
	•	Prepare and submit a preliminary bid letter to purchase non-investment grade bonds;
	•	Commence underwriting process for loans in collateral pool including physical site inspection;
	•	Review re-underwriting data for the entire pool;
	•	Submit bond purchase to investment committee for approval;
	•	Submit bond purchase to executive committee of the board of directors for approval;
	•	Complete final pricing and structuring of investment; and
	•	Fund investment.

      We re-underwrite the underlying commercial mortgage loans securing the CMBS. We analyze the estimate of underwriteable cash flow and analyze necessary carve-outs, such as replacement reserves. We study the trends of the industry and geographic location of each property, and independently assess our own estimate of the anticipated cash flow over the period of the loan. Our loan officers and consultants physically inspect the collateral properties, and assess appraised values based on our own opinion of comparable market values.

      Based on the findings of our diligence procedures, we may reject certain mortgage loans from inclusion in the pool. We then formulate our negotiated price and discount to achieve an effective loss-adjusted yield on our investment over a ten-year period to approximate 13% to 16%.

      CMBS transactions are approved by an investment committee consisting of our most senior officers and chaired by our Chairman and Chief Executive Officer, William L. Walton. CMBS transactions over $10 million are reviewed and approved by the executive committee of the board of directors.

Portfolio

      Portfolio Diversity. We monitor the portfolio to maintain industry diversity. We currently do not have a policy with respect to “concentrating” (i.e., investing 25% or more of our total assets) in any industry or group of industries and currently our portfolio is not concentrated. We may or may not concentrate in any industry or group of industries in the future.

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      Loan Servicing.  Our loan servicing staff is responsible for routine loan servicing, which includes:

	•	delinquency monitoring;
	•	payment processing;
	•	borrower inquiries;
	•	escrow analysis and processing;
	•	third-party reporting; and
	•	insurance and tax administration.

      In addition, our staff is responsible for special servicing activities including delinquency monitoring and collection, workout administration, and management of foreclosed assets.

      Portfolio by Grade. We employ a standard grading system for the 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, 2002 and 2001, our portfolio was graded as follows:

		2002								2001
						Percentage								Percentage
		Portfolio				of Total				Portfolio				of Total
Grade		at Value				Portfolio				at Value				Portfolio
($ in millions)
1		$	801.0				32.1	%		$	603.3				25.9	%
2			1,400.8				56.3				1,553.8				66.7
3			166.0				6.7				79.5				3.4
4			23.6				1.0				44.5				1.9
5			96.8				3.9				48.5				2.1
		$	2,488.2				100.0	%		$	2,329.6				100.0	%

      Total Grades 4 and 5 assets as a percentage of the total portfolio at value at December 31, 2002 and 2001, were 4.9% and 4.0%, respectively. Included in Grades 4 and 5 assets at December 31, 2002 and 2001, were assets totaling $24.1 million and $6.6 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 Grades 4 and 5 may fluctuate from period to period. We continue to follow our historical practice of working with a troubled portfolio company in order to recover the maximum amount of our investment, but record unrealized depreciation for the expected amount of the loss when such exposure is identified.

      At December 31, 2002, we saw an increase in Grade 3 assets in this difficult economy. We have been working with a number of portfolio companies that are in the

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      Loans and Debt Securities on Non-Accrual Status. Loans and debt securities on non-accrual status for which we have doubt about interest collection and are in workout status are classified as Grade 4 or 5 assets. In addition, we may not accrue interest on loans and debt securities to companies that are more than 50% owned by us from time to time if such companies are in need of additional capital. In these situations we may choose to defer current debt service.

      For the total investment portfolio, workout loans and debt securities (which excludes equity securities that are included in the total Grade 4 and 5 assets above) not accruing interest that were classified in Grade 4 and 5, were $89.1 million at value at December 31, 2002, or 3.6% of the total portfolio. Included in this category at December 31, 2002, were loans of $13.0 million that were secured by commercial real estate. Workout loans and debt securities not accruing interest were $85.0 million at value at December 31, 2001, or 3.6% of the total portfolio, of which $8.9 million was related to portfolio companies in liquidation, and $4.1 million represented loans secured by commercial real estate. As of December 31, 2002, $7.6 million representing receivables related to portfolio companies in liquidation were included in other assets. In addition to Grade 4 and 5 assets that are in workout, loans and debt securities to companies that are more than 50% owned by us that were not accruing interest totaled $63.6 million at value at December 31, 2002, and loans and debt securities to companies that are less than 50% owned by us that were not in workout but were not accruing interest totaled $7.2 million and $23.9 million at value at December 31, 2002, and 2001, respectively.

      Loans and Debt Securities Over 90 Days Delinquent. Loans and debt securities greater than 90 days delinquent were $103.1 million at value at December 31, 2002, or 4.1% of the total portfolio. Included in this category were loans valued at $26.0 million that were secured by commercial real estate. Loans and debt securities greater than 90 days delinquent were $39.1 million at value at December 31, 2001, or 1.7% of the total portfolio. Included in this category were loans valued at $14.1 million that were secured by commercial real estate.

      As a provider of long-term privately negotiated investment capital, we may defer payment of principal or interest from time to time. As a result, the amount of the portfolio that is greater than 90 days delinquent or on non-accrual status may vary from quarter to quarter. The nature of our private finance portfolio company relationships frequently provide an opportunity for portfolio companies 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. 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 investments for a total return including interest or dividends plus capital gains from the sale of equity securities. Therefore, the amount of loans and debt securities greater than 90 days delinquent or on non-accrual status 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.

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      At December 31, 2002 and 2001, 1.0% and 0.5%, respectively, of the loans in the underlying collateral pool for our CMBS bond portfolio were over 30 days delinquent or were classified as real estate owned. We closely monitor the performance of all of the loans in the underlying collateral pools securing our CMBS investments.

      Portfolio Monitoring. We monitor loan delinquencies in order to assess the appropriate course of action and overall portfolio quality. With respect to our private finance portfolio, investment professionals closely monitor the status and performance of each individual investment throughout each quarter. This portfolio company monitoring process includes discussions with the senior management team of the company’s financial performance, the review of current financial statements, and generally includes attendance at portfolio company board meetings. Through the process, investments that may require closer monitoring are generally detected early, and for each such investment, an appropriate course of action is determined. For the private finance portfolio, loan delinquencies or payment default is not necessarily an indication of credit quality or the need to pursue active workout of a portfolio investment. Because we are a provider of long-term privately negotiated investment capital, it is not atypical for us to defer payment of principal or interest from time to time. As a result, the amount of our private finance portfolio that is delinquent at any one time may vary. The nature of our private finance portfolio relationships frequently provide an opportunity for us to restructure the debt and equity capital of the portfolio company. During such restructuring, we may not receive or accrue interest or dividend payments. Our senior investment professionals actively work with the portfolio company in these instances to negotiate an appropriate course of action.

      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 investments for a total return including current interest or dividends plus capital gains from sale of equity securities. Therefore, the amount of loans that are 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 loss of investment principal. We expect that a certain number of portfolio companies will be in the Grade 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 Grades 4 and 5 may fluctuate from quarter to quarter. We continue to follow our historical practice of working with a troubled portfolio company in order to recover the maximum amount of our investment, but record unrealized depreciation for the amount of the loss when such exposure is identified.

      With respect to our CMBS portfolio, we monitor the performance of the individual loans in the underlying collateral pool through market data and discussions with the pool master servicers and special servicers. The master servicers are responsible for the day-to-day loan servicing functions, including billing, payment processing, collections on loans less than 60 days past due, tax and insurance escrow processing, and property inspections. The special servicers are responsible for collections on loans greater than 60 days past due, including workout administration and management of foreclosed properties. We discuss the status of past due or underperforming loans with the master servicers on a monthly basis. When a loan moves to a special servicer, a workout plan is formulated by the special servicer and generally reviewed by us as the directing certificate holder. Once reviewed by us, the special servicer carries out the workout plan, updating us on the status. We generally have the ability to replace the named special servicer at any time.

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      We act as the disposition consultant with respect to three of our collateralization debt obligations, or CDO investments, which allows us to approve disposition plans for individual collateral securities. For these services, we collect annual fees based on the outstanding collateral pool balance.

      Business Loan Express. Our single largest portfolio investment is in Business Loan Express (BLX). BLX is the nation’s second largest non-bank government guaranteed lender utilizing the SBA’s 7(a) Guaranteed Loan Program and is licensed by the SBA as a Small Business Lending Company (SBLC). In addition to the 7(a) Guaranteed Loan Program, BLX originates conventional small business loans and originates loans under the USDA Business and Industry Guaranteed Loan Program.

      BLX originates small business loans and then sells or securitizes substantially all of the loans it originates and retains servicing on the loans sold. BLX currently sells the guaranteed piece of SBA 7(a) guaranteed loans and securitizes the unguaranteed pieces of the SBA 7(a) loans and conventional loans it originates. Typically, BLX retains up to 2.7% of the term loan securitization pools.

      BLX focuses its loan origination activity on small businesses that are owner-operated and generally secures its loans with single-purpose real estate associated with the business such as limited service hotels, gas stations and convenience stores, full-service restaurants, and manufacturing and retail properties. In addition, BLX has made loans to shrimp and fishing businesses that secure their loans with the shrimp or fishing vessel.

      Summary serviced loan portfolio data for BLX at December 31, 2002, was as follows:

($ in millions)			December 31, 2002
Total serviced loan portfolio			$	1,619.5
Number of loans serviced				2,373
Serviced Loan Portfolio By Industry
	Hotels			26	%
	Gas stations/convenience stores			19
	Restaurants			10
	Manufacturing and industrial			10
	Professional and retail services			9
	Shrimp/fishing vessels			6
	Recreation			5
	Child care and health care services			4
	Other			11
	Total			100	%

      BLX closely monitors its portfolio as well as the industries in which its borrowers operate. BLX’s loan servicing and special servicing departments actively work with each borrower to assess BLX’s financial exposure to troubled situations. At December 31, 2002, BLX’s loan delinquencies in its serviced portfolio were 8.6%.

      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. For these reasons, BLX focuses on collateral protection for each loan in addition to the cash flow of the small business and receives personal guarantees from the principal owners of the small business.

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      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 impact on BLX or its operations. As of October 1, 2002, the SBA implemented a maximum loan size of $500,000 for loans originated through the SBA 7(a) Guaranteed Loan Program due to Federal budget constraints. In February 2003, legislation was enacted to return the SBA 7(a) Guaranteed Loan Program to a sufficient level of funding. This legislation has enabled the SBA to return the maximum loan size to previous levels.

Portfolio Valuation

      Valuation Methodology. We determine the value of each investment in our portfolio on a quarterly basis, and changes in value result in unrealized gains or losses being recognized. At December 31, 2002, approximately 89% of our total assets represented portfolio investments recorded at fair value. 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. 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 company does not currently support the cost of our debt or equity investment. Conversely, 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 unrealized gains and losses.

      As a business development company, we invest in illiquid securities including debt and equity securities of primarily private companies and non-investment grade CMBS. 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 examination of, among

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      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 monthly 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 upon 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 accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America. 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 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 are determined based on various factors, including the enterprise value remaining for equity holders after the repayment of the portfolio company’s debt and other pertinent factors such as recent offers to purchase a portfolio company’s equity interest or other potential liquidity events. The determined

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      Valuation Methodology — CMBS Bonds. CMBS bonds are carried at fair value, which is based on a discounted cash flow model, which utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable market yields for similar CMBS bonds. Our assumption with regard to discount rate is based on the yield of comparable securities. 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 estimates of future credit losses, actual losses incurred, or actual and estimated prepayment speeds. 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. We recognize unrealized appreciation or depreciation on our CMBS bonds as comparable yields in the market change and based on changes in estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool.

      Valuation Process. The following is a description of the steps we take each quarter to determine the value of our portfolio.

	•	Our quarterly valuation process begins with each portfolio company or investment being initially valued by the investment professionals responsible for the portfolio investment, led by the Managing Director who is responsible for the relationship.
	•	Preliminary valuation conclusions are then discussed and documented in a valuation write-up and/ or worksheet and then discussed with our portfolio management team under the supervision of the Chief Financial Officer.
	•	The investment committee, consisting of our most senior officers and chaired by our Chairman and Chief Executive Officer, William L. Walton, meets to discuss valuations as preliminarily determined and documented by each deal team, questions the valuation data and conclusions, and arrives at an investment committee view of valuation.
	•	The investment committee provides comments on the preliminary valuation and the deal team and portfolio management team respond and supplement the documentation based upon those comments.
	•	The valuation documentation is updated and distributed to our board of directors and the audit committee of the board of directors.
	•	The audit committee meets in advance of the board of directors to discuss the valuations and supporting documentation.
	•	The board of directors meets to discuss valuations and review the input of the audit committee and management.
	•	To the extent changes or additional information is deemed necessary, a follow-up board meeting, executive committee meeting or audit committee meeting may take place.
	•	The board of directors determines the fair value of the portfolio in good faith.

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Investment Gains and Losses

      Since the majority of our portfolio consists of loans and debt securities, our investment decisions are primarily based on credit dynamics. Our underwriting focuses on the preservation of principal, and we will pursue our available means to recover our capital investment. As a result of this investment discipline and credit culture, we have a demonstrated track record of successfully resolving troubled credit situations. Our realized gains from the sale of our equity interests have historically exceeded losses, as is reflected in the chart below.

		Year Ended December 31,
		2002				2001				2000				1999				1998
($ in thousands)
Realized gains		$	95,562			$	10,107			$	28,604			$	31,536			$	25,757
Realized losses		$	(50,625	)		$	(9,446	)		$	(13,081	)		$	(6,145	)		$	(3,216	)
Net realized gains		$	44,937			$	661			$	15,523			$	25,391			$	22,541

Employees

      At December 31, 2002, we employed 105 individuals including investment and portfolio management professionals, operations professionals and administrative staff. The majority of these individuals are located in the Washington, DC office. We believe that our relations with our employees are excellent.

LEGAL PROCEEDINGS

      On April 21, 2003, the U.S. District Court for the Southern District of New York dismissed a consolidated securities class action lawsuit alleging violations of the federal securities laws filed against us and certain of our officers. In its ruling, the court found that the plaintiffs had failed to allege sufficient facts to support their claim and, therefore, dismissed the lawsuit in its entirety.

      We are party to certain other lawsuits including legal proceedings incidental to the normal course of our business including enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.

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PORTFOLIO COMPANIES

      The following is a listing of our portfolio companies in which we had an equity investment at December 31, 2002. The portfolio companies are presented in three categories — companies more than 25% owned which represent portfolio companies where we directly or indirectly own more than 25% of the outstanding voting securities of such portfolio company and, therefore, are deemed controlled by us under the 1940 Act; companies owned 5% to 25% which represent portfolio companies where we directly or indirectly own 5% to 25% of the outstanding voting securities of such portfolio company or where we hold 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 we directly or indirectly own less than 5% of the outstanding voting securities of such portfolio company and where we have no other affiliations with such portfolio company.

      We make available significant managerial assistance to our portfolio companies. We generally receive rights to observe the meetings of our portfolio companies’ board of directors, and may have one or more voting seats on their boards. For information relating to the amount and nature of our investments in portfolio companies, see our consolidated statement of investments at December 31, 2002 at pages F-6 to F-16.

							Percentage
Name and Address			Nature of its		Title of Securities		of Class
of Portfolio Company			Principal Business		Held by the Company		Held(1)
Companies More Than 25% Owned
Acme Paging, L.P.(2)(3)			Paging Services		Equity Interests			1.8%
	6080 SW 40th Street, Suite 3				Equity Interests
	Miami, FL 33155				in Affiliate			76.9%
American Healthcare Services, Inc.(2)(3)			Consumer Health		Common Stock			80.3%
	3600 Mansell Road		Services Provider
	Suite 150
	Alpharetta, GA 30022
Avborne, Inc.(3)			Aviation Services		Series B Preferred Stock			23.8%
	c/o Trivest, Inc.				Common Stock			27.5%
	7500 NW 26th Street
	Miami, FL 33122
Business Loan Express, Inc.(2)(3)			Small Business Lender		Preferred Stock			100.0%
	645 Madison Ave.				Common Stock			94.9%
	19th Floor
	New York, NY 10022
The Color Factory Inc.(2)(3)			Cosmetic Manufacturer		Redeemable Preferred
	11312 Penrose Street				Stock			100.0%
	Sun Valley, CA 91352				Common Stock			100.0%
Elmhurst Consulting, LLC(2)(3)			Consulting Firm		Equity Interest			100%
	360 W. Butterfield Road,				Common Stock in
	Suite 400				Controlled Company			95.0%
	Elmhurst, IL 60126
Foresite Towers, LLC(2)(3)			Tower Leasing		Common Equity Interest			70.0%
	22 Iverness Center Parkway				Series A Preferred
	Suite 50				Equity Interest			100.0%
	Birmingham, AL 35242				Series B Preferred
					Equity Interest			100.0%
Gordian Group, Inc.(2)(3)			Financial Advisory Services		Common Stock			100.0%
	499 Park Avenue
	5th Floor
	New York, NY 10022

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							Percentage
Name and Address			Nature of its		Title of Securities		of Class
of Portfolio Company			Principal Business		Held by the Company		Held(1)
HealthASPex, Inc.(2)(3)			Third Party		Class A Convertible
	Foxpointe Centre		Administrator		Preferred Stock			69.9%
	Building 1; Suite 301				Class B Convertible
	201 South Johnson Road				Preferred Stock			64.8%
	Houston, PA 15342				Common Stock			45.8%
The Hillman Companies, Inc.(2)(3)			Merchandiser of Retail		Common Stock			96.8%
	10590 Hamilton Avenue		Hardware Supplies
	P.O. Box 31012
	Cincinnati, OH 45231
HMT, Inc.			Storage Tank		Class B Preferred
	4422 FM 1960 West		Maintenance &		Stock			33.2%
	Suite 350		Repair		Common Stock			26.1%
	Houston, TX 77068				Warrants to Purchase
					Common Stock			10.0%
Housecall Medical Resources, Inc.(2)(3)			Home Healthcare		Preferred Stock			86.4%
	6501 Deane Hill Drive		Services		Common Stock			86.4%
	Knoxville, TN 37919
Litterer Beteiligungs-GmbH			Scaffolding Company		Equity Interest			15.0%
	Uhlandstrasse 1
	69493 Hirschberg
	Germany
MVL Group, Inc.(2)(3)			Market Research		Common Stock			64.9%
	1061 E. Indiantown Road		Services
	Suite 300
	Jupiter, FL 33477
Powell Plant Farms, Inc.(2)(3)			Plant Retailer		Preferred Stock			100%
	Route 3, Box 1058				Warrants to Purchase
	Troup, TX 75789				Common Stock			83.5%
Redox Brands, Inc.(3)			Household Cleaning		Series A Convertible
	9100 Centre Point Drive		Products		Preferred Stock			100.0%
	Suite 200				Warrants to Purchase
	West Chester, OH 45069				Class A Common Stock			8.2%
Staffing Partners Holding Company, Inc.			Temporary Employee		Redeemable Preferred
	104 Church Lane #100		Services		Stock			48.3%
	Baltimore, MD 21208				Class A-1 Common
					Stock			50.0%
					Class A-2 Common
					Stock			24.4%
					Class B Common
					Stock			24.0%
					Warrants to purchase
					Class B Preferred Stock			71.4%
					Warrants to purchase
					Class B Common Stock			54.1%
STS Operating, Inc. (d/b/a SunSource Technology Services, Inc.)(3)			Engineering Design and		Preferred Stock			96.2%
	2301 Windsor Court		Services		Common Stock			41.0%
	Addison, IL 60101
Sure-Tel, Inc.(3)			Prepaid Telephone		Preferred Stock			50.0%
	5 North McCormick		Services Company		Common Stock			37.0%
	Oklahoma City, OK 73127
Companies 5% to 25% Owned
Aspen Pet Products, Inc.			Pet Product		Series B Preferred Stock			9.5%
	4735 North Florence Street		Provider		Series A Common Stock			7.0%
	Denver, CO 80238
Autania AG			Machine and Tool		Common Stock			6.2%
	Industriestrasse 7		Manufacturer
	65779 Kelkheim
	Germany

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							Percentage
Name and Address			Nature of its		Title of Securities		of Class
of Portfolio Company			Principal Business		Held by the Company		Held(1)
Border Foods, Inc.			Mexican Ingredient &		Series A Convertible
	J Street		Food Product		Preferred Stock			9.4%
	Deming Industrial Park		Manufacturer		Warrants to Purchase
	Deming, NM 88030				Common Stock			88.6%
CorrFlex Graphics, LLC(3)			Packaging Manufacturer		Warrants to Purchase
	701 Rickert Street				Common Stock			4.8%
	Statesville, NC 28677				Options to Purchase
					Common Stock			7.0%
CyberRep(3)			Operator of Call Service		Warrants to Purchase
	8300 Greensboro Drive, 6th Floor		Centers		Common Stock			40.5%
	McLean, VA 22102
The Debt Exchange, Inc.			Online Sales of		Series B Convertible
	101 Arch Street, Suite 410		Distressed Assets		Preferred Stock			40.0%
	Boston, MA 02110
EDM Consulting, LLC			Environmental		Equity Interest			25.0%
	81 Two Bridges Road		Consulting
	Fairfield, NJ 07004
International Fiber Corporation			Cellulose and Fiber		Common Stock			11.7%
	50 Bridge Street		Producer		Warrants to Purchase
	North Tonawanda, NY 14120				Common Stock			3.0%
Liberty-Pittsburgh Systems, Inc.			Business Forms Printing		Common Stock			17.0%
	3498 Grand Avenue
	Pittsburgh, PA 15225
Logic Bay Corporation			Computer-Based		Series C Redeemable
	7900 International Drive		Training Developer		Preferred Stock			29.4%
	Suite 750
	Minneapolis, MN 55425
Magna Card, Inc.			Magnet Packager		Preferred Stock			6.3%
	10315 South Dolifield Rd.		and Distributor		Common Stock			5.4%
	Owings Mills, MD 21117
Master Plan, Inc.			Healthcare Outsourcing		Common Stock			7.5%
	21540 Plummer Street
	Chatsworth, CA 91311
MortgageRamp.com, Inc.(3)			Internet Based		Class A Common
	116 Welsh Road		Loan Origination		Stock			7.7%
	Horsham, PA 19044		Service Platform
Morton Grove Pharmaceuticals, Inc.			Generic Drug		Convertible
	6451 West Main Street		Manufacturer		Preferred Stock			23.9%
	Morton Grove, IL 60053
Nobel Learning Communities, Inc.			Educational Services		Series D Convertible
	1400 N. Providence Road,				Preferred Stock			100.0%
	Suite 3055				Warrants to Purchase
	Media, PA 19063				Common Stock			11.7%
Packaging Advantage Corporation			Personal Care,		Common Stock			11.3%
	4633 Downey Road		Household and		Warrants to Purchase
	Los Angeles, CA 90058		Disinfectant Product		Common Stock			5.4%
			Packager
Professional Paint, Inc.			Paint Manufacturer		Series A-1 Senior
	8600 Park Meadow Drive, #300				Exchangeable Preferred
	Lone Tree, CO 80124				Stock			50.0%
					Common Stock			13.8%
Progressive International
	Corporation		Retail Kitchenware		Series A Redeemable
	6111 S. 228th Street				Preferred Stock			12.5%
	P.O. Box 97045				Common Stock			1.1%
	Kent, WA 98064				Warrants to Purchase
					Common Stock			45.3%
Prosperco Finanz Holding AG			Financial Services		Debt Convertible into
	Schützengasse 25				Common Stock			8.5%
	CH-8001 Zürich				Common Stock			2.6%
	Switzerland				Warrants to Purchase
					Common Stock			5.0%

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								Percentage
Name and Address				Nature of its		Title of Securities		of Class
of Portfolio Company				Principal Business		Held by the Company		Held(1)
Total Foam, Inc.				Packaging Systems		Common Stock			8.8%
	P.O. Box 688
	Ridgefield, CT 06877
Companies Less Than 5% Owned
Advantage Sales and Marketing, Inc.				Regional Food		Warrants to Purchase
	3444 Memorial Highway			Broker		Common Stock			4.5%
	Tampa, FL 33607
Alderwoods Group, Inc.				Death Care Services		Common Stock			0.9%
	311 Elm Street, Suite 1000
	Cincinnati, OH 45202
Allied Office Products, Inc.				Office Products		Common Stock			3.1%
	100 Dellawanna Avenue
	Clifton, NJ 07014
American Barbecue & Grill, Inc.				Restaurant Chain		Warrants to Purchase
	7300 W. 110th Street, Suite 570					Common Stock			18.7%
	Overland Park, KS 66210
ASW Holding Corporation				Steel Wool Manufacturer		Warrants to Purchase
	2825 W. 31st Street					Common Stock			5.9%
	Chicago, IL 60623
Blue Rhino Corporation				Propane Cylinder		Warrants to Purchase
	104 Cambridge Plaza Drive			Exchange		Common Stock			7.7%
	Winston-Salem, NC 27104
Camden Partners Strategic Fund II, L.P.				Private Equity Fund		Limited Partnership
	One South Street					Interest			4.2%
	Suite 2150
	Baltimore, MD 21202
Candlewood Hotel Company				Extended Stay		Series A Convertible
	9342 East Central			Facilities		Preferred Stock			2.4%
	Wichita, KS 67206					Series B Convertible
						Preferred Stock			4.1%
Celebrities, Inc.				Radio Stations		Warrants to Purchase
	408-412 W. Oakland Park					Common Stock			25.0%
		Boulevard
	Ft. Lauderdale, FL 33311-1712
Colibri Holding Corporation				Outdoor Living Products		Preferred Stock			5.9%
	2201 S. Walbash Street					Common Stock			4.2%
	Denver, CO 80231					Warrants to Purchase
						Common Stock			2.4%
Component Hardware Group, Inc.				Designer & Developer		Class A Preferred Stock			9.6%
	1890 Swarthmore Ave.			of Hardware		Common Stock			13.3%
	P.O. Box 2020			Components
	Lakewood, NJ 08701
Cooper Natural Resources, Inc.				Sodium Sulfate Producer		Series A Convertible
	P.O. Box 1477					Preferred Stock			100.0%
	Seagraves, TX 79360					Warrants to Purchase
						Series A Convertible Preferred Stock			36.8%
						Warrants to Purchase
						Common Stock			6.5%
eCentury Capital Partners, L.P.				Private Equity Fund		Limited Partnership
	8270 Greensboro Drive					Interest			25.0%
	Suite 1025
	McLean, VA 22102
Elexis Beta GmbH				Distance Measurement		Options to Purchase
	Ulmenstraße 22			Device		Shares			9.8%
	60325 Frankfurt am Main			Manufacturer
	Germany
E-Talk Corporation				Telecommunications		Warrants to Purchase
	4040 West Royal Lane			Software Provider		Common Stock			5.5%
	Suite 100
	Irving, TX 75063

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							Percentage
Name and Address			Nature of its		Title of Securities		of Class
of Portfolio Company			Principal Business		Held by the Company		Held(1)
Executive Greetings, Inc.			Personalized Business		Warrants to Purchase
	120 Industrial Park Access Road		Products		Common Stock			1.3%
	New Hartford, CT 06057
Fairchild Industrial Products Company			Industrial Controls		Warrants to Purchase
	3920 Westpoint Boulevard		Manufacturer		Common Stock			22.4%
	Winston-Salem, NC 27013
Frozen Specialties, Inc.			Private Label Frozen		Warrants to Purchase
	720 Barre Road		Food Manufacturer		Class A Common Stock			2.7%
	Archbold, OH 43502
Galaxy American Communications, LLC			Cable Television		Options to Purchase
	1100 N. Main Street		Operator		Common LLC Interest			51.2%
	Sikeston, MO 63801
Garden Ridge Corporation			Home Decor Retailer		Series A Preferred Stock			2.6%
	19411 Atrium Place				Class A Common Stock			4.7%
	Suite 170				Class B Common Stock			4.7%
	Houston, TX 77084
Gibson Guitar Corporation(3)			Guitar Manufacturer		Warrants to Purchase
	1818 Elm Hill Pike				Class A Common Stock			3.0%
	Nashville, TN 37210				Warrants to Purchase
					Class B Common Stock			3.0%
Ginsey Industries, Inc.			Bathroom Accessories		Convertible Debentures			8.3%
	281 Benigno Boulevard		Manufacturer		Warrants to Purchase
	Bellmawr, NJ 08031				Common Stock			17.1%
Global Communications, LLC			Muzak Franchisee		Preferred Equity Interest			59.3%
	201 East 69th Street				Options for Common
	New York, NY 10021				Membership Interest			59.3%
Grant Broadcasting Systems II			Television Stations		Warrants to Purchase
	919 Middle River Drive,				Common Stock			25.0%
	Suite 409				Warrants to Purchase
	Ft. Lauderdale, FL 33304				Common Stock in
					Affiliate Company			25.0%
Grotech Partners VI, L.P.			Private Equity Fund		Limited Partnership
	c/o Grotech Capital Group				Interest			2.6%
	9690 Deereco Road
	Suite 800
	Timonium, MD 21093
The Hartz Mountain Corporation			Pet Supply		Common Stock			2.0%
	400 Plaza Drive		Manufacturer		Warrants to Purchase
	Secaucus, NJ 07094				Common Stock			4.3%
Hotelevision, Inc.			Hotel Cable-TV		Series 3
	599 Lexington Avenue		Network		Preferred Stock			16.2%
	Suite 2300
	New York, NY 10022
Icon International, Inc.			Corporate Barter		Class A Common Stock			0.8%
	281 Tressor Boulevard		Services		Class C Common Stock			0.2%
	8th Floor
	Stamford, CT 06901
Impact Innovations Group, LLC			Information Technology		Warrants to Purchase
	2500 Northwinds Parkway		Services Provider		Common Stock			3.5%
	Suite 200
	Alpharetta, GA 30004
Interline Brands, Inc.			Repair and Maintenance		Senior Preferred Stock			0.8%
	303 Harper Drive		Product Distributor		Common Stock			0.9%
	Moorestown, NJ 08057				Warrants to Purchase
					Common Stock			1.4%
JRI Industries, Inc.			Machinery Manufacturer		Warrants to Purchase
	2958 East Division				Common Stock			6.5%
	Springfield, MO 65803

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							Percentage
Name and Address			Nature of its		Title of Securities		of Class
of Portfolio Company			Principal Business		Held by the Company		Held(1)
Julius Koch USA, Inc.			Mini-Blind Cord		Warrants to Purchase
	387 Church Street		Manufacturer		Common Stock			39.6%
	New Bedford, MA 02745 C
Kirker Enterprises, Inc.			Nail Enamel		Equity Interest in
	55 East 6th Street		Manufacturer		Affiliate Company			22.5%
	Paterson, NJ 07524				Warrants to Purchase
					Series B Common Stock			22.5%
Kirkland’s, Inc.			Home Furnishing		Common Stock			1.3%
	P.O. Box 7222		Retailer
	Jackson, TN 38308-7222
Kyrus Corporation			Value-Added Reseller,		Warrants to Purchase
	5 Artillery Road		Computer Systems		Common Stock			18.4%
	Taylors, SC 29687
Love Funding Corporation			Mortgage Services		Series D Preferred Stock			26.0%
	1220 19th Street, NW, Suite 801
	Washington, DC 20036
Matrics, Inc.			Radio Frequency		Series B Convertible
	8850 Stanford Boulevard		Identification Technology		Preferred Stock			3.4%
	Suite 3000				Warrants to Purchase			0.2%
	Columbia, MD 21045				Series B Convertible
					Preferred Stock
MedAssets Inc.			Healthcare Outsourcing		Series B Convertible
	100 Northpoint Center				Preferred Stock			6.4%
	East #150				Warrants to Purchase
	Alpharetta, GA 30022				Common Stock			0.2%
Mid-Atlantic Venture Fund IV, L.P.			Private Equity Fund		Limited Partnership
	128 Goodman Drive				Interest			6.7%
	Bethlehem, PA 18015
Midview Associates, L.P.			Residential Land		Warrants to Purchase
	2 Eaton Street, Suite 1101		Development		Partnership Interests			35.0%
	Hampton, VA 23669
Norstan Apparel Shops, Inc.			Women’s Apparel Retailer		Common Stock			26.3%
	33-00 47th Avenue				Warrants to Purchase
	Long Island City, NY 11101				Common Stock			8.0%
North American Archery Group, LLC			Sporting Equipment		Debentures Convertible
	4600 SW 41st Boulevard		Manufacturer		into LLC Equity
	Gainsville, FL 32608				Interest			26.9%
Novak Biddle Venture Partners III, L.P.			Private Equity Fund		Limited Partnership
	7501 Wisconsin Avenue				Interest			2.9%
	East Tower, Suite 1380
	Bethesda, MD 20814
Nursefinders, Inc.			Healthcare		Warrants to Purchase
	1200 Copeland Road, Suite 200		Services		Common Stock			4.1%
	Arlington, TX 76011
Onyx Television GmbH			Cable Television		Preferred Units			12.0%
	Immedia Park 6b
	50670 Koln
	Germany
Opinion Research Corporation			Corporate Marketing		Warrants to Purchase
	P.O. Box 183		Research Firm		Common Stock			6.8%
	Princeton, NJ 08542
Oriental Trading Company, Inc.			Direct Marketer		Series A Redeemable
	108th Street, 4206 South		of Toys		Preferred Stock			1.7%
	Omaha, NE 68137				Class A Common Stock			1.7%
Outsource Partners, Inc.			Outsourced Facility		Warrants to Purchase
	200 Mansell Court East		Services Provider		Preferred Stock			4.0%
	Suite 500				Warrants to Purchase
	Roswell, GA 30076				Class A Common Stock			5.4%

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							Percentage
Name and Address			Nature of its		Title of Securities		of Class
of Portfolio Company			Principal Business		Held by the Company		Held(1)
Polaris Pool Systems, Inc.			Pool Cleaner		Warrants to Purchase
	P.O. Box 1149		Manufacturer		Class B Common Stock			4.6%
	San Marcos, CA 92079-1149
Raytheon Aerospace, LLC			Aviation Maintenance and		Class B LLC Interest			6.7%
	555 Industrial Drive South		Logistics
	Madison, MS 39110
Soff-Cut Holdings, Inc.			Concrete Sawing		Series A Preferred Stock			14.3%
	1112 Olympic Drive		Equipment Manufacturer		Common Stock			2.7%
	Corona, CA 91719
Spa Lending Corporation			Health Spas		Series A Preferred Stock			100.0%
	1919 Pennsylvania Avenue, N.W.
	Washington, DC 20006
Sydran Food Services II, L.P.			Fast Food Franchise		Class A Preferred Units			3.4%
	Bishop Ranch 8				Class B Common Units			1.7%
	3000 Executive Parkway				Warrants to Purchase
	Ste. 515				Class B Common Units			12.0%
	San Ramon, CA 94583-4254
Tubbs Snowshoe Company, LLC			Snowshoe Manufacturer		Equity Interests in
	52 River Road				Affiliate Company			7.0%
	Stowe, VT 05672				Warrants to Purchase
					Common Units in Affiliate Company			8.5%
United Pet Group, Inc.			Manufacturer of Pet		Warrants to Purchase
	463 Ohio Pike		Products		Common Stock			5.8%
	Suite 303
	Cincinnati, OH 45255
Updata Venture Partners II, L.P.			Private Equity Fund		Limited Partnership
	11600 Sunrise Valley Drive				Interest			16.1%
	Reston, VA 20191
Venturehouse Group, LLC			Private Equity Fund		Common Equity Interest			2.2%
	1780 Tysons Blvd., Suite 400
	McLean, VA 22102
Walker Investment Fund II, LLLP			Private Equity Fund		Limited Partnership
	3060 Washington Road				Interest			5.1%
	Suite 200
	Glenwood, MD 21738
Warn Industries, Inc.			Sport Utility Accessories		Warrants to Purchase
	12900 S.E. Capps Rd.		Manufacturer		Common Stock			48.6%
	Clackamas, OR 97015
Wilshire Restaurant Group, Inc.			Restaurant Chain		Warrants to Purchase
	1100 Town & Country Road				Common Stock			2.7%
	Suite 1300				Warrants to Purchase
	Orange, CA 92868-4654				Preferred Stock			2.7%
Woodstream Corporation			Pest Control		Equity Interest in
	69 North Locust Street		Manufacturer		Affiliate Company			13.7%
	Lititz, PA 17543				Warrants to Purchase
					Common Stock			7.2%

(1)	Percentages shown for securities held by us represent percentage of the class owned and do not necessarily represent voting ownership. Percentages shown for equity securities other than warrants or options represent the actual percentage of the class of security held before dilution. Percentages shown for warrants and options held represent the percentage of class of security we may own, on a fully diluted basis, assuming we exercise our warrants or options.
(2)	We directly or indirectly own more than 50% of the voting securities of the company, or control the board of directors, or are the controlling member.
(3)	The portfolio company is deemed to be an affiliated person under the 1940 Act because we hold one or more seats on the portfolio company’s board of directors, are the general partner, or are the managing member.

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      We determine the net asset value per share of our common stock quarterly. The net asset value per share is equal to the value of our total assets minus liabilities and preferred stock divided by the total number of common shares outstanding.

      At December 31, 2002, approximately 89% of our total assets represented portfolio investments recorded at fair value. 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. 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 company does not currently support the cost of our debt or equity investment. Conversely, 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 unrealized gains and losses.

      As a business development company, we invest in illiquid securities including debt and equity securities of primarily private companies and non-investment grade CMBS. 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 examination of, among other things, the underlying investment performance, financial condition, and market changing events that impact valuation.

      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

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      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 monthly 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 accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America. 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 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 are determined based on various factors, including the enterprise value remaining for equity holders after the repayment of the portfolio company’s debt and other pertinent factors such as recent offers to purchase a portfolio company’s equity interest or other potential liquidity 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.

      Loans and Debt Securities. For loans and debt securities, fair value generally approximates cost unless the borrower’s enterprise value or 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

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      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 classified as Grade 4 or Grade 5 assets 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 if such companies are in need of additional capital. Loan origination fees, original issue discount, and market discount are capitalized and then amortized into interest income using the effective interest method. Prepayment premiums are recorded on loans when received.

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

      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’s securities or other liquidation events. The determined fair 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 upon 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”). CMBS bonds are carried at fair value, which is based upon a discounted cash flow model that utilizes prepayment and loss assumptions based upon historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable market yields for similar CMBS bonds. Our assumption with regard to discount rate for determining fair value is based on the yield of comparable securities. 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 estimates of future credit losses, actual losses incurred, or actual and estimated prepayment speeds. 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. We recognize unrealized appreciation or depreciation on our CMBS bonds as comparable yields in the market change and based on changes in

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      Residual Interest. We value our residual interest from a previous securitization and recognize income using the same accounting policies used for the CMBS bonds. The residual interest is carried at fair value based on discounted estimated future cash flows. We recognize income from the residual interest using the effective interest method. At each reporting date, the effective yield is recalculated and used to recognize income until the next reporting date.

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MANAGEMENT

      Our Board of Directors supervises our management. The responsibilities of each director include, among other things, the oversight of the investment approval process, the quarterly valuation of our assets, and oversight of our financing arrangements. The Board of Directors maintains an Executive Committee, Audit Committee, Compensation Committee, and Nominating Committee, and may establish additional committees in the future. Some or all of our directors also serve as directors of our subsidiaries.

      Our investment decisions in each business area are made by investment committees composed of our most senior investment professionals. No one person is primarily responsible for making recommendations to a committee.

      We are internally managed and our investment professionals manage our portfolio and the portfolios of companies for which we serve as investment adviser. These investment professionals have extensive experience in managing investments in private businesses in a variety of industries, and are familiar with our approach of lending and investing. Because we are internally managed, we pay no investment advisory fees, but instead we pay the operating costs associated with employing investment management professionals.

Structure of Board of Directors

      The Board of Directors is classified into three approximately equal classes with three-year terms, with only one of the three classes expiring each year. Directors serve until their successors are elected and qualified.

Directors

      Information regarding the board of directors is as follows:

								Director				Expiration
Name		Age				Position		Since(1)				of Term
Interested Directors(2)
William L. Walton			53			Chairman, Chief Executive
						Officer and President			1986				2004
George C. Williams, Jr.			76			Chairman Emeritus			1964				2004
Robert E. Long			71			Director			1972				2004
Independent Directors
Brooks H. Browne			53			Director			1990				2004
John D. Firestone			59			Director			1993				2005
Anthony T. Garcia			46			Director			1991				2005
Ann Torre Grant			45			Director			2003				2006
Lawrence I. Hebert			56			Director			1989				2005
John I. Leahy			72			Director			1994				2006
Alex J. Pollock			60			Director			2003				2006
Guy T. Steuart II			71			Director			1984				2006
Laura W. van Roijen			51			Director			1992				2005

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(1)	Includes service as a director of any of the predecessor companies.
(2)	Interested persons of Allied Capital, as defined in the Investment Company Act of 1940.

      Each director has the same address as Allied Capital, 1919 Pennsylvania Avenue, N.W., Washington, D.C. 20006.

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Executive Officers

      Information regarding our executive officers is as follows:

Name		Age				Position
William L. Walton			53			Chairman, Chief Executive Officer and President
Joan M. Sweeney			43			Chief Operating Officer
Penni F. Roll			37			Chief Financial Officer
Scott S. Binder			48			Managing Director
Michael J. Grisius			39			Managing Director
Robert D. Long			46			Managing Director
Edward H. Ross			37			Managing Director
John M. Scheurer			50			Managing Director
John D. Shulman			40			Managing Director
Paul R. Tanen			36			Managing Director
Thomas H. Westbrook			39			Managing Director
G. Cabell Williams, III			48			Managing Director
Scott A. Somer			34			Director of Financial Operations
Suzanne V. Sparrow			37			Executive Vice President and Secretary

      Each executive officer has the same address as Allied Capital, 1919 Pennsylvania Avenue, N.W., Washington, D.C. 20006.

Biographical Information

Directors

      Our directors have been divided into two groups — interested directors and independent directors. Interested directors are interested persons as defined in the Investment Company Act of 1940.

Interested Directors

      William L. Walton has been the Chairman, Chief Executive Officer, and President of Allied Capital since 1997. He has served on Allied Capital’s Board of Directors since 1986, and was named Chairman and CEO in February 1997. Mr. Walton previously served as Managing Director of New York-based Butler Capital Corporation, a mezzanine buyout firm, and was the personal venture capital advisor for William S. Paley, founder and Chairman of CBS. In addition, he was a Senior Vice President in Lehman Brothers Kuhn Loeb’s Investment Banking Group. Mr. Walton also founded and managed two start-up businesses, Success Lab, Inc. and Language Odyssey, in the emerging education industry (1992–1996). Mr. Walton is a director of Riggs National Corporation, The Hillman Companies, Inc., and the National Venture Capital Association.

      George C. Williams, Jr. is Chairman Emeritus of Allied Capital. Mr. Williams was an officer of the predecessor companies from the later of 1959 or the inception of the relevant entity and President or Chairman and Chief Executive Officer of the predecessor companies from the later of 1964 or each entity’s inception until 1991. Mr. Williams is the father of G. Cabell Williams III, an executive officer of Allied Capital.

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      Robert E. Long has been the Chief Executive Officer and a director of Goodwyn, Long & Black Investment Management, Inc. since 1997, and has been the Chairman of Emerald City Radio Partners, LLC since 1997. Mr. Long was the President of Business News Network, Inc. from 1995 to 1998, the Chairman and Chief Executive Officer of Southern Starr Broadcasting Group, Inc. from 1991 to 1995, and a director and the President of Potomac Asset Management, Inc. from 1983 to 1991. Mr. Long is a director of AmBase Corporation, CSC Scientific, Inc., Advanced Solutions International, Inc. and Graphic Computer Solutions, Inc. Mr. Long is the father of Robert D. Long, an executive officer of Allied Capital.

Independent Directors

      Brooks H. Browne is a private investor. Mr. Browne was the President of Environmental Enterprises Assistance Fund from 1993 to 2002. He is a director of SEAF and Solar Development Capital, Ltd.

      John D. Firestone has been a Partner of Secor Group (venture capital) since 1978. Mr. Firestone is a director of Security Storage Company of Washington, DC, and served as a director of Bryn Mawr Bank Corporation from 1998 to 2001. Mr. Firestone is currently a member of the board of several non-profit organizations.

      Anthony T. Garcia has been Vice President of Finance of Formity Systems, Inc., a developer of software products for business management of data networks, since January 2002. Mr. Garcia was a private investor from 2000 to 2001, the General Manager of Breen Capital Group (investor in tax liens) from 1997 to 2000, and a Senior Vice President of Lehman Brothers Inc. from 1985 to 1996.

      Ann Torre Grant is a strategic and financial consultant. From 1995 to 1997, Ms. Grant served as Executive Vice President, CFO and Treasurer of NHP, Inc., a national real estate services firm. From 1991 to 1995, Ms. Grant was Vice President and Treasurer of US Airways. She serves on the boards of Franklin Mutual Series and SLM Corporation (Sallie Mae).

      Lawrence I. Hebert has been a director and President and Chief Executive Officer of Riggs Bank N.A. (a subsidiary of Riggs National Corporation) since February 2001, and has served as a director of Riggs National Corporation since 1988. Mr. Hebert also serves as a director of Riggs Investment Management Corporation and Riggs Bank Europe Limited (both indirect subsidiaries of Riggs National Corporation). Mr. Hebert is the President and a director of Perpetual Corporation (owner of Allbritton Communications Company and ALLNEWSCO, Inc.). Mr. Hebert is a director of ALLNEWSCO, Inc. (news programming service), the President of Westfield News Advertiser, Inc. (owner of a television station and newspapers), a Trustee of The Allbritton Foundation, and Vice Chairman of Allbritton Communications Company. Mr. Hebert previously served as Vice Chairman (1983 to 1998), President (1984 to 1998), and Chairman and Chief Executive Officer (1998 to 2001) of Allbritton Communications Company. Riggs Bank N.A. has a $60 million commitment under our revolving line of credit.

      John I. Leahy has been the President of Management and Marketing Associates, a management consulting firm, since 1986. Mr. Leahy was the President and Group Executive Officer, Western Hemisphere of Black & Decker Corporation from 1982 to 1985. Mr. Leahy is a director of B&L Sales, Inc. and is the Chairman of Gallagher Fluid Seals, Inc. Mr. Leahy is Trustee Emeritus of the Sellinger School of Business, Loyola College, Maryland.

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      Alex J. Pollock has been President and Chief Executive Officer of the Federal Home Loan Bank of Chicago since 1991. He also serves as a director of the Great Lakes Higher Education Corporation and the Great Books Foundation. Mr. Pollock is Past President of the International Union for Housing Finance and the Bankers Club of Chicago.

      Guy T. Steuart II has been a director and President of Steuart Investment Company, which manages, operates, and leases real and personal property and holds stock in operating subsidiaries engaged in various businesses, since 1960. Mr. Steuart is Trustee Emeritus of Washington and Lee University.

      Laura W. van Roijen has been a private investor since 1992.

Executive Officers who are not Directors

      Joan M. Sweeney, Chief Operating Officer, has been employed by Allied Capital since 1993. Ms. Sweeney oversees Allied Capital’s daily operations. Prior to joining Allied Capital, Ms. Sweeney was employed by Ernst & Young, Coopers & Lybrand, and the SEC Division of Enforcement.

      Penni F. Roll, Chief Financial Officer, has been employed by Allied Capital since 1995. Ms. Roll is responsible for Allied Capital’s financial operations. Prior to joining Allied Capital, Ms. Roll was employed by KPMG LLP.

      Scott S. Binder, Managing Director, has been employed by Allied Capital in the private finance investment group since 1997 and was a consultant to Allied Capital from 1991 until 1997. Prior to joining Allied Capital, Mr. Binder formed and was President of Overland Communications Group. He has also worked in the specialty finance and leasing industry.

      Michael J. Grisius, Managing Director, has been employed by Allied Capital since 1992. Prior to joining Allied Capital, Mr. Grisius worked in corporate finance at Chemical Bank and was employed by KPMG LLP.

      Robert D. Long, Managing Director, joined Allied Capital in its private finance investment group in 2002. Prior to joining Allied Capital, Mr. Long was Managing Director and Head of Investment Banking at C.E. Unterberg from 2001 to 2002, and Managing Director at E*OFFERING/Wit SoundView from 2000 to 2001. He also held management positions at Bank of America (Montgomery Securities) from 1996 to 2000, and Nomura Securities International, from 1992 to 1996, and prior to that he served as a Managing Director at CS First Boston.

      Edward H. Ross, Managing Director, joined Allied Capital in its private finance investment group in 2002. Prior to joining Allied Capital, Mr. Ross co-founded and served as a Managing Director of Leveraged Capital at Wachovia Securities (previously First Union Securities) from 1998 to 2002, a merchant banking arm for the firm. He also held management positions in First Union’s Leveraged Finance Group from 1994 to 1998.

      John M. Scheurer, Managing Director, has been employed by Allied Capital in the commercial real estate investment group since 1991. Prior to joining Allied Capital, Mr. Scheurer worked with Capital Recovery Advisors, Inc. and First American Bank. He also started his own company, The Scheurer Company, and co-founded Hunter Associates, a leasing and consulting real estate firm in the Washington, DC area.

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      John D. Shulman, Managing Director, has been employed by Allied Capital in the private finance investment group since 2001. Prior to joining Allied Capital, Mr. Shulman served as the President and CEO of Onyx International, LLC from 1995 to 2001. He currently serves as a director of ChemLink Laboratories LLC and as a member of the investment committees of Taiwan Mezzanine Fund and Greater China Private Equity Fund.

      Paul R. Tanen, Managing Director, has been employed by Allied Capital in the private finance investment group since 2000. Prior to joining Allied Capital, Mr. Tanen served as a Managing Director at Ridgefield Partners from 1998 to 2000, and was a Founding Member of the private equity group at Charter Oak Partners from 1992 to 1998.

      Thomas H. Westbrook, Managing Director, has been employed by Allied Capital in the private finance investment group since 1991. Prior to joining Allied Capital, Mr. Westbrook worked with the North Carolina Enterprise Fund and was a Lending Officer in NationsBank’s corporate lending unit.

      G. Cabell Williams, III, Managing Director, has been employed by Allied Capital in the private finance investment group since 1981. Mr. Williams has served in many capacities during his tenure with Allied Capital.

      Scott A. Somer, Director of Financial Operations, has been employed by Allied Capital since 1998. Mr. Somer is responsible for managing the accounting and loan servicing activities. Prior to joining Allied Capital, Mr. Somer was employed by KPMG LLP.

      Suzanne V. Sparrow, Executive Vice President and Corporate Secretary, has been employed by Allied Capital since 1987. Ms. Sparrow manages our investor relations activities.

Committees of the Board of Directors

      Our Board of Directors has established an Executive Committee, an Audit Committee, a Compensation Committee and a Nominating/Corporate Governance Committee.

      The Executive Committee has and may exercise those rights, powers and authority that the Board of Directors from time to time grants to it, except where action by the full Board is required by statute, an order of the SEC or our charter or bylaws. The Executive Committee also reviews and approves all investments of $10 million or more. The Executive Committee met 32 times during 2002. The 2003 Executive Committee currently consists of Messrs. Walton, Firestone, Hebert, Leahy, Long, Steuart, and Williams.

      The Audit Committee operates pursuant to a charter approved by the Board of Directors, a copy of which is included as Exhibit A to our proxy statement for the 2003 Annual Meeting of Stockholders. The charter sets forth the responsibilities of the Audit Committee. The Audit Committees’ responsibilities include recommending the selection of independent public accountants for Allied Capital, reviewing with such independent public accountants the planning, scope and results of their audit of our financial statements and the fees for services performed, reviewing with the independent public accountants the adequacy of internal control systems, reviewing our annual financial statements and receiving our audit reports and financial statements. The Audit Committee met 13 times during 2002. The 2003 Audit Committee currently consists of Messrs. Browne and Garcia

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      The Compensation Committee determines the compensation for our executive officers and the amount of salary and bonus to be included in the compensation package for each of our officers and employees. In addition, the Compensation Committee approves stock option grants for our officers under our stock option plan. The Compensation Committee met six times during 2002. The 2003 Compensation Committee currently consists of Messrs. Leahy, Browne, and Garcia.

      The Nominating/Corporate Governance Committee recommends candidates for election as directors to the Board of Directors and makes recommendations to the Board as to our corporate governance policies. The Nominating/Corporate Governance Committee met once during 2002. The 2003 Nominating/Corporate Governance Committee currently consists of Messrs. Hebert, Browne, and Pollock and Ms. van Roijen.

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COMPENSATION OF EXECUTIVE OFFICERS AND DIRECTORS

      Under SEC rules applicable to business development companies, we are required to set forth certain information regarding the compensation of certain executive officers and directors. The following table sets forth compensation paid during the year ended December 31, 2002 to all of our directors and our three highest paid executive officers (collectively, the “Compensated Persons”) in each capacity in which each Compensated Person served. Certain of the Compensated Persons served as both officers and directors.

      Our directors have been divided into two groups — interested directors and independent directors. Interested directors are “interested persons” as defined in the Investment Company Act of 1940.

Compensation Table

										Pension or
										Retirement
										Benefits
		Aggregate				Securities				Accrued as
		Compensation				Underlying				Part of				Directors
		from the				Options/				Company				Fees by the
Name		Company(1,2)				SARs(4)				Expenses(2)				Company(5)
Interested Directors:
William L. Walton, Chairman and CEO		$	2,617,819				612,200				—			$	—
George C. Williams, Jr., Director and Chairman Emeritus(3)			170,000				5,000				—				26,000
Robert E. Long, Director			31,000				5,000				—				31,000
Independent Directors:
Brooks H. Browne, Director			44,000				5,000				—				44,000
John D. Firestone, Director			19,000				5,000				—				19,000
Anthony T. Garcia, Director			23,000				5,000				—				23,000
Lawrence I. Hebert, Director			25,000				5,000				—				25,000
John I. Leahy, Director			37,000				5,000				—				37,000
Guy T. Steuart II, Director			25,000				5,000				—				25,000
Laura W. van Roijen, Director			22,000				5,000				—				22,000
Executive Officers:
Joan M. Sweeney, Chief Operating Officer			1,827,615				462,281				—				—
Thomas H. Westbrook, Managing Director			1,588,942				425,625				—				—

(1)	We paid no perquisites in excess of the lesser of $50,000 or 10% of the Compensated Person’s total salary and bonus for the year.
(2)	The following table provides detail as to aggregate compensation paid during 2002 as to our three highest paid executive officers:

						Bonus and				Other
		Salary				Awards				Benefits
Mr. Walton		$	519,231			$	2,025,000			$	73,588
Ms. Sweeney			360,000				1,425,000				42,615
Mr. Westbrook			256,308				1,305,000				27,634

	Included for each executive officer in “Bonus and Awards” is an annual bonus and retention award.  Included for each executive officer in “Other Benefits” is an employer contribution to the 401(k) Plan, life insurance premiums, disability insurance, and a contribution to the Deferred Compensation Plan. See also “Employment Agreements”.

(3)	In addition to director’s fees, Mr. Williams received $144,000 in consulting fees.
(4)	See “Stock Option Awards” for terms of options granted in 2002. We do not maintain a restricted stock plan or a long-term incentive plan.
(5)	Consists only of directors’ fees we paid during 2002. Such fees are also included in the column titled “Aggregate Compensation from the Company.”

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Compensation of Directors

      During 2002, each director received a $10,000 annual retainer in lieu of per meeting fees; directors who serve on the Executive Committee received a $25,000 annual retainer in lieu of per meeting fees. Members of each committee other than the Executive Committee received $1,000 for each committee meeting attended during the year. In addition, the chairpersons of the Audit and Compensation Committees each received a $3,000 annual retainer for their additional services in these capacities. Our Chairman and CEO, William L. Walton, did not receive directors’ fees.

      For 2003, each non-officer director will receive an annual retainer of $40,000. In addition, committee chairs will receive an annual retainer of $5,000. For each meeting attended during 2003, Executive Committee members will receive $1,000 per meeting; Audit Committee members will receive $2,500 per meeting; and members of the Compensation and Nominating/ Corporate Governance Committees will receive $1,500 per meeting.

      Non-officer directors are eligible for stock option awards under our stock option plan pursuant to an exemptive order from the SEC. The terms of the order, which was granted in September 1999, provided for a one-time grant of 10,000 options to each non-officer director on the date that the order was issued, or on the date that any new director is elected by stockholders to the Board of Directors. Thereafter, each non-officer director will receive 5,000 options each year on the date of the annual meeting of shareholders at the fair market value on the date of grant. See “Stock Option Plan.”

Stock Option Awards

      The following table sets forth the details relating to option grants in 2002 to Compensated Persons under our Stock Option Plan, and the potential realizable value of each grant, as prescribed to be calculated by the SEC. See “Stock Option Plan.”

Options Grants During 2002

																		Potential Realizable
																		Value at Assumed
		Number of																Annual Rates
		Securities				Percent of												Of Stock Appreciation
		Underlying				Total Options				Exercise								Over 10-Year Term(3)
		Options				Granted				Price Per				Expiration
Name		Granted(1)				In 2002(2)				Share				Date				5%				10%
Interested Directors:
William L. Walton			612,200				9.94%			$	21.52				12/13/12			$	8,285,400			$	20,996,830
George C. Williams, Jr.			5,000				0.08%				21.52				12/13/12				67,669				171,487
Robert E. Long			5,000				0.08%				25.97				5/7/12				81,662				206,947
Independent Directors:
Brooks H. Browne			5,000				0.08%				25.97				5/7/12				81,662				206,947
John D. Firestone			5,000				0.08%				25.97				5/7/12				81,662				206,947
Anthony T. Garcia			5,000				0.08%				25.97				5/7/12				81,662				206,947
Lawrence I. Hebert			5,000				0.08%				25.97				5/7/12				81,662				206,947
John I. Leahy			5,000				0.08%				25.97				5/7/12				81,662				206,947
Guy T. Steuart II			5,000				0.08%				25.97				5/7/12				81,662				206,947
Laura W. van Roijen			5,000				0.08%				25.97				5/7/12				81,662				206,947
Executive Officers:
Joan M. Sweeney			462,281				7.50%				21.52				12/13/12				6,256,424				15,855,008
Thomas H. Westbrook			425,625				6.91%				21.52				12/13/12				5,760,329				14,597,804

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(1)	Options granted to officers in 2002 generally vest in three equal installments beginning on June 30, 2003, with full vesting occurring on June 30, 2005, or upon a change of control of Allied Capital. Options granted to non-officer directors vest immediately.
(2)	In 2002, we granted options to purchase a total of 6,161,763 shares.
(3)	Potential realizable value is calculated on 2002 options granted, and is net of the option exercise price but before any tax liabilities that may be incurred. These amounts represent certain assumed rates of appreciation, as mandated by the Commission. Actual gains, if any, or stock option exercises are dependent on the future performance of the shares, overall market conditions, and the continued employment by us of the option holder. The potential realizable value will not necessarily be realized.

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     The following table sets forth the details of option exercises by Compensated Persons during 2002 and the values of those unexercised options at December 31, 2002.

Option Exercises and Year-End Option Values

										Number of Securities								Value of Unexercised
										Underlying Unexercised								In-the-Money Options
		Shares								Options as of 12/31/02								as of 12/31/02(2)
		Acquired on				Value
Name		Exercise				Realized(1)				Exercisable				Unexercisable				Exercisable				Unexercisable
Interested Directors:
William L. Walton			16,782			$	154,478				1,251,189				1,188,912			$	3,256,557			$	1,725,198
George C. Williams, Jr.			—				—				156,396				19,999				98,896				11,339
Robert E. Long			—				—				25,000				—				21,650				—
Independent Directors:
Brooks H. Browne			—				—				25,000				—				21,650				—
John D. Firestone			—				—				25,000				—				21,650				—
Anthony T. Garcia			—				—				25,000				—				21,650				—
Lawrence I. Hebert			—				—				25,000				—				21,650				—
John I. Leahy			—				—				25,000				—				21,650				—
Guy T. Steuart II			—				—				25,000				—				21,650				—
Laura W. van Roijen			—				—				25,000				—				21,650				—
Executive Officers:
Joan M. Sweeney			20,569				157,047				583,193				745,027				1,428,798				802,588
Thomas H. Westbrook			—				—				295,677				599,234				1,067,700				670,945

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(1)	Value realized is calculated as the closing market price on the date of exercise, net of option exercise price, but before any tax liabilities or transaction costs. This is the deemed market value, which may actually be realized only if the shares are sold at that price.
(2)	Value of unexercised options is calculated as the closing market price on December 31, 2002 ($21.83), net of the option exercise price, but before any tax liabilities or transaction costs. “In-the-Money Options” are options with an exercise price that is less than the market price as of December 31, 2002.

Employment Agreements

      We have entered into employment agreements with six of our senior executives, including William L. Walton, our Chairman and CEO, Joan M. Sweeney, Chief Operating Officer, and Thomas H. Westbrook, Managing Director. Each of the agreements provides for a three-year term expiring on June 15, 2003, with annual renewals thereafter, and specifies each executive’s compensation during the term of the agreement, in accordance with the achievement of certain performance standards.

      The Board of Directors has the right to increase the base salary during the term of the employment agreement. In addition, each employment agreement states that the Board of Directors may provide, at their sole discretion, an annual cash bonus. This bonus is to be determined with reference to each executive’s performance in accordance with performance criteria to be determined by the board in its sole discretion. Under each agreement, each executive also is entitled to participate in our Stock Option Plan, and to receive all other awards and benefits previously granted to each executive including life insurance premiums.

      In addition, each employment agreement provides for a long-term cash retention award for the performance period from 2001 through 2003. The long-term cash retention award vests and is payable in six installments on June 30th and December 31st of each year from 2001 through 2003. For 2003, Mr. Walton will be eligible for a long-term cash retention award of $1,125,000; Ms. Sweeney will be eligible for $850,000; and Mr. Westbrook will be eligible for $1,105,000.

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      Employment will terminate if the term of the agreement expires without written agreement of both parties. The executive has the right to voluntarily terminate employment at any time with 30 days’ notice, and in such case, the employee will not receive any severance pay. Among other things, the employment agreements prohibit the solicitation of our employees in the event of an executive’s departure for a period of two years.

      If employment is terminated with cause, the employee will not receive any severance pay. If employment is terminated without cause during the term of the agreement, the executive shall be entitled to severance pay for a period not to exceed 36 months for Mr. Walton; 30 months for Ms. Sweeney; and 24 months for Mr. Westbrook. Severance pay shall include the continuation of the employee’s base salary, and the greater of (a) the average of the annual bonuses paid during the preceding three years, or (b) the amount of the last annual bonus paid to the employee. In addition, the executive shall be entitled to receive any payments under the long-term cash retention award that would have vested and been payable during the severance period. However, stock options would cease to vest during the severance period.

      If, within 12 months after a change of control (as defined in the employment agreements), termination of employment occurs either by the executive officer or us, the executive officer shall not be entitled to severance pay, but will instead be entitled to lump sum compensation as well as certain other benefits. For Mr. Walton, this lump sum is equal to three years of base salary and bonus (as calculated for severance pay), plus an amount equal to $5,565,000. For Ms. Sweeney, this lump sum is equal to two and a half years of base salary and bonus, plus an amount equal to $2,600,000. For Mr. Westbrook, this lump sum is equal to two years of base salary and bonus, plus an amount equal to $2,350,000. Under the terms of these agreements, we would also provide compensation to offset any applicable excise tax penalties imposed on the executive under section 4999 of the Internal Revenue Code.

      Certain other executive officers have employment agreements that carry terms substantially similar to those of Mr. Westbrook’s agreement, as described herein.

Compensation Plans

Stock Option Plan

      Our Stock Option Plan is intended to encourage stock ownership in the Company by officers and directors, thus giving them a proprietary interest in our performance. The Stock Option Plan was most recently approved by stockholders on May 7, 2002.

      The Compensation Committee’s principal objective in awarding stock options to our eligible officers is to align each optionee’s interests with our success and the financial interests of our stockholders by linking a portion of such optionee’s compensation with the performance of our stock and the value delivered to stockholders.

      Stock options are granted under the Stock Option Plan at a price not less than the prevailing market value and will have value only if our stock price increases. The Compensation Committee determines the amount and features of the stock options, if any, to be awarded to optionees. The Compensation Committee evaluates a number of criteria, including the past service of each such optionee to Allied Capital, the present and potential contributions of such optionee to the success of Allied Capital and such other factors as the Compensation Committee shall deem relevant in connection with accomplishing the purposes of the Stock Option Plan, including the recipient’s current stock holdings, years of service, position with Allied Capital and other factors. The

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      On September 8, 1999, we received approval from the Commission to grant options under the Stock Option Plan to non-officer directors. On that date, each incumbent non-officer director received options to purchase 10,000 shares, and pursuant to the Commission order, each will receive options to purchase 5,000 shares each year thereafter on the date of the annual meeting of stockholders. New directors will receive options to purchase 10,000 shares upon election by stockholders to the Board of Directors, and options to purchase 5,000 shares each year thereafter on the date of the annual meeting.

      The Stock Option Plan is designed to satisfy the conditions of Section 422 of the Code so that options granted under the Stock Option Plan may qualify as “incentive stock options.” To qualify as “incentive stock options,” options may not become exercisable for the first time in any year if the number of incentive options first exercisable in that year multiplied by the exercise price exceeds $100,000.

401(k) Plan

      We maintain a 401(k) plan (the “401(k) Plan”). All full-time employees who are at least 21 years of age have the opportunity to contribute pre-tax salary deferrals into the 401(k) Plan up to $12,000 annually for the 2003 plan year, and to direct the investment of these contributions. Plan participants who reach the age of 50 during the 2003 plan year will be eligible to defer an additional $2,000 during 2003. The 401(k) Plan allows eligible participants to invest in shares of our common stock among other investment options. In addition, we expect to contribute to each participant, up to 5% of each participant’s eligible compensation for the year, up to a maximum compensation of $200,000, to each participant’s plan account on the participant’s behalf, which fully vests at the time of the contribution. The contribution with respect to compensation in excess of $200,000 is made to the Deferred Compensation Plan. On February 28, 2003, the 401(k) Plan held less than 1% of our outstanding shares.

Deferred Compensation Plan

      We maintain a deferred compensation plan (the “Deferred Compensation Plan”). The Deferred Compensation Plan is an unfunded plan, as defined by the Internal Revenue Code of 1986, as amended (the “Code”), that provides for the deferral of compensation by our employees and consultants. Our employees or consultants are eligible to participate in the plan at such time and for such period as designated by the Board of Directors. The Deferred Compensation Plan is administered through a trust, and we fund this plan through cash contributions.

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CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES

      As of June 4, 2003, there were no persons that owned 25% or more of our outstanding voting securities, and no person would be deemed to control us, as such term is defined in the 1940 Act.

      The following table sets forth, as of June 4, 2003, information with respect to the beneficial ownership of our common stock by the shareholders who owned more than 5% of our outstanding shares of common stock, each current director, the chief executive officer, our executive officers and our executive officers and directors as a group. Unless otherwise indicated, we believe that each beneficial owner set forth in the table has sole voting and investment power.

      Our directors have been divided into two groups — interested directors and independent directors. Interested directors are “interested persons” as defined in the Investment Company Act of 1940.

										Dollar Range of
		Number of								Equity Securities
Name of		Shares Owned				Percentage				Beneficially Owned
Beneficial Owner		Beneficially(8)				of Class(1)				by Directors(9)
Capital Research and Management Company			7,384,000	(11)			6.53	%
333 South Hope Street, 55th Floor
Los Angeles, CA 90071-1447
Interested Directors:
William L. Walton			2,513,094	(2,4,7)			2.19	%		over $	100,000
George C. Williams, Jr.			445,115	(2,7)			*			over $	100,000
Robert E. Long			42,111	(3)(2)			*			over $	100,000
Independent Directors:
Brooks H. Browne			73,713	(3)			*			over $	100,000
John D. Firestone			61,756	(3,7)			*			over $	100,000
Anthony T. Garcia			88,512	(3)			*			over $	100,000
Ann Torre Grant			10,000	(3)			—				none
Lawrence I. Hebert			51,800				*			over $	100,000
John I. Leahy			47,318				*			over $	100,000
Alex J. Pollock			13,200	(7)(3)			*			$	10,001–$50,000
Guy T. Steuart II			354,244				*			over $	100,000
Laura W. van Roijen			60,376	(3,7)			*			over $	100,000
Executive Officers:
Scott S. Binder			585,484	(2,7)			*
Michael J. Grisius			382,778	(2,7)			*
Robert D. Long			235,786	(2,7,10)			*
Penni F. Roll			346,019	(2)			*
Edward H. Ross			101,946				*
John M. Scheurer			989,368	(2)			*
John D. Shulman			305,119	(2)			*
Scott A. Somer			40,979	(2,7)			*
Suzanne V. Sparrow			182,317	(2)			*
Joan M. Sweeney			1,196,452	(2)			1.05	%
Paul R. Tanen			271,225	(2)			*

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		Number of
Name of		Shares Owned				Percentage
Beneficial Owner		Beneficially(8)				of Class(1)
Thomas H. Westbrook			720,916	(2,7)			*
G. Cabell Williams III			1,132,430	(2,4)			1.00	%
All directors and executive officers as a group (25 in number)			9,907,080	(6)			8.26	%

	(1)	Based on a total of 113,162,545 shares of our common stock issued and outstanding on June 4, 2003, and 6,845,878 shares of our common stock issuable upon the exercise of immediately exercisable stock options held by individual executive officers and non-officer directors.
	(2)	Share ownership for the following directors and executive officers includes:

						Options
						Exercisable
		Owned				Within 60 Days				Allocated to
		Directly				of June 4, 2003				401(k) Plan
Interested Directors:
William L. Walton			444,797				1,814,435				3,724
George C. Williams, Jr.			287,052				158,063				—
Robert E. Long			12,111				30,000
Executive Officers:
Scott S. Binder			77,709				506,191				1,584
Michael J. Grisius			55,346				312,448				14,984
Robert D. Long			19,000				215,786				1,000
Penni F. Roll			83,096				255,108				7,815
John M. Scheurer			279,936				678,423				31,009
John D. Shulman			4,799				300,320				—
Scott A. Somer			742				39,650				587
Suzanne V. Sparrow			78,881				82,236				21,200
Joan M. Sweeney			298,966				884,549				12,937
Paul R. Tanen			5,161				266,064				—
Thomas H. Westbrook			190,541				530,375				—
G. Cabell Williams III			438,284				440,284				92,309

	(3)	Beneficial ownership for these non-officer directors includes exercisable options to purchase 10,000 shares for Mr. Pollack and Ms. Grant and 30,000 shares for all others.
	(4)	Includes 253,862 shares held by the 401(k) Plan, of which Messrs. Walton and Williams III are co-trustees. Messrs. Walton and Williams III disclaim beneficial ownership of such shares.
	(5)	Includes 276,691 shares held by a corporation for which Mr. Steuart II serves as an executive officer.
	(6)	Includes a total of 6,845,878 shares underlying stock options exercisable within 60 days of June 4, 2003, which are assumed to be outstanding for the purpose of calculating the group’s percentage ownership, and 253,862 shares held by the 401(k) Plan.
	(7)	Includes certain shares held in IRA or Keogh accounts: Walton — 12,015 shares; Williams Jr. — 20,798 shares; Firestone — 2,745 shares; R.D. Long — 15,000 shares; Pollock — 1,000 shares; van Roijen — 4,920 shares; Binder — 273 shares; Grisius — 885 shares; Somer — 257 shares; Westbrook — 16,365 shares.
	(8)	Beneficial ownership has been determined in accordance with Rule 13d-3 of the Securities Exchange Act of 1934.
	(9)	Beneficial ownership has been determined in accordance with Rule 16-1(a)(2) of the Securities Exchange Act of 1934.

(10)	Includes 4,000 shares held by a trust for the benefit of Mr. Long’s children.
(11)	Information regarding share ownership was obtained from the Schedule 13G that Capital Research and Management Company filed with the SEC on May 15, 2003.

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CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

      The following table sets forth certain information, as of February 28, 2003, regarding indebtedness to us in excess of $60,000 of any person serving as a director or executive officer of the Company at any time since January 1, 2002. All of such indebtedness results from loans we made to enable the exercise of stock options. The loans are required to be fully collateralized as full recourse against the borrower and have varying terms not exceeding ten years. The interest rates charged generally reflect the applicable federal rate on the date of the loan. As of December 31, 2002, the total loans outstanding to such directors and executive officers of the Company was $18,251,087 or 0.7% of the Company’s total assets at December 31, 2002.

      As a business development company under the Investment Company Act of 1940, we are entitled to provide loans to employees in connection with the exercise of options. However, as a result of provisions of the Sarbanes-Oxley Act of 2002, we are prohibited from making new loans to, or materially modifying existing loans with, our executive officers in the future.

		Highest Amount												Amount
		Outstanding				Range of								Outstanding at
Name and Position with Company		During 2002				Interest Rates								February 28, 2003
Interested Directors(1):
William L. Walton, Chairman and CEO		$	2,997,228				4.45	%		–	6.24	%		$	2,997,228
George C. Williams, Jr., Director, Chairman Emeritus			1,850,386				5.89	%		–	6.24	%			1,850,386
Executive Officers:
Joan M. Sweeney, Chief Operating Officer			2,231,157				4.45	%		–	6.63	%			2,231,157
Penni F. Roll, Chief Financial Officer			1,273,924				4.45	%		–	6.24	%			1,273,924
Scott S. Binder, Managing Director			979,492				4.66	%		–	5.89	%			703,869
Michael J. Grisius, Managing Director			277,837				3.91	%		–	4.68	%			266,988
John M. Scheurer, Managing Director			2,537,259				4.73	%		–	6.63	%			2,345,719
John D. Shulman, Managing Director			99,991				2.85	%		–	2.85	%			99,991
Paul R. Tanen, Managing Director			99,994				3.91	%		–	3.91	%			99,994
Thomas H. Westbrook, Managing Director			2,405,138				4.98	%		–	6.24	%			1,516,681
G. Cabell Williams III, Managing Director			3,887,054				4.77	%		–	6.24	%			3,543,410
Suzanne V. Sparrow, Executive Vice President and Secretary			923,112				4.45	%		–	6.18	%			753,506

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(1)	Interested directors are “interested persons” as defined by the Investment Company Act of 1940.

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TAX STATUS

      The following discussion is a general summary of the material United States federal income tax considerations applicable to us and to an investment in our common stock. This summary does not purport to be a complete description of the income tax considerations applicable to such an investment. The discussion is based upon the Internal Revenue Code, Treasury Regulations, and administrative and judicial interpretations, each as of the date of this prospectus and all of which are subject to change. You should consult your own tax advisor with respect to tax considerations that pertain to your purchase of our common stock.

      This summary is intended to apply to investments in our common stock and assumes that investors hold our common stock as capital assets. This summary does not discuss all aspects of federal income taxation relevant to holders of our common stock in light of particular circumstances, or to certain types of holders subject to special treatment under federal income tax laws, including dealers in securities, pension plans and trusts and financial institutions. This summary does not discuss any aspects of U.S. estate and gift tax or foreign, state or local tax. It does not discuss the special treatment under federal income tax laws that could result if we invested in tax-exempt securities or certain other investment assets.

      Except as specifically indicated herein, this summary is intended to apply to U.S. Stockholders (as defined below) and does not purport to discuss all U.S. federal income tax consequences to persons who are not U.S. Stockholders (“Non-U.S. Stockholders”) from an investment in the common stock. (A “U.S. Stockholder” is a stockholder who is (i) a citizen or resident of the United States, (ii) a corporation or partnership created in or organized under the laws of the United States or any political subdivision thereof, (iii) an estate, the income of which is subject to United States federal income taxation regardless of its source, or (iv) a trust subject to the supervision of a court within the United States and the control of a United States person.) Non-U.S. Stockholders should consult their own tax advisors to discuss the consequences of an investment in our common stock.

Taxation as a Regulated Investment Company

      We intend to be treated for tax purposes as a “regulated investment company” under Subchapter M of the Internal Revenue Code. If we (i) qualify as a regulated investment company and (ii) distribute to stockholders in a timely manner at least 90% of our “investment company taxable income,” as defined in the Internal Revenue Code (i.e., net ordinary investment income, including accrued original issue discount, and net short-term capital gain in excess of net long-term capital loss) (the “90% Distribution Requirement”) each year, we generally will not be subject to federal income tax on the portion of our investment company taxable income and net capital gain (i.e., net long-term capital gain in excess of net short-term capital loss) we distribute (or treat as “deemed distributed”) to stockholders. (We will, however, be subject to such tax to the extent that, prior to February 2, 2013, BLX sells property held by BLX, Inc. on the date of its corporate reorganization, but only, to the extent (i) such property had a built-in gain (that is, value in excess of tax basis) on such date and (ii) such built-in gain is recognized on such sale.) In addition, if we distribute in a timely manner an amount at least equal to the sum of (i) 98% of our ordinary income for each calendar year, (ii) 98% of our capital gain net income for the one-year period ending December 31 of that calendar year, and (iii) any income not distributed in prior years, we will not be subject to the 4% nondeductible

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      In order to qualify as a regulated investment company for federal income tax purposes, we must, among other things: (a) continue to qualify as a business development company under the 1940 Act; (b) derive in each taxable year at least 90% of our gross income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities, or other income derived with respect to our business of investing in such stock or securities (the “90% Income Test”); and (c) diversify our holdings so that at the end of each quarter of the taxable year (i) at least 50% of the value of our assets consists of cash, cash items, U.S. government securities, securities of other regulated investment companies, and other securities if such other securities of any one issuer do not represent more than 5% of our assets or more than 10% of the outstanding voting securities of the issuer, and (ii) no more than 25% of the value of our assets is invested in the securities (other than U.S. government securities or securities of other regulated investment companies) of any one issuer or of two or more issuers that are controlled (as determined under applicable Internal Revenue Code rules) by us and are engaged in the same or similar or related trades or businesses (the “Diversification Tests”). The failure of one or more of our subsidiaries to continue to qualify as regulated investment companies could adversely affect our ability to satisfy the Diversification Tests.

      If we acquire or are deemed to have acquired debt obligations that were issued originally at a discount or that otherwise are treated under applicable tax rules as having original issue discount, we must include in income each year a portion of the original issue discount that accrues over the life of the obligation regardless of whether cash representing such income is received by us in the same taxable year. Any amount accrued as original issue discount will be included in our investment company taxable income for the year of accrual and may have to be distributed to the stockholders in order to satisfy the 90% Distribution Requirement or the Excise Tax Avoidance Requirements even though we have not received any cash representing such income.

      Although we do not currently intend to do so, if we were to invest in certain options, futures, or forward contracts, we may be required to report income from such investments on a mark-to-market basis, which could result in us recognizing unrealized gains and losses for federal income tax purposes even though we may not realize such gains and losses when we ultimately dispose of such investments. We could also be required to treat such gains and losses as 60% long-term capital gain or loss and 40% short-term capital gain or loss regardless of our holding period for the investments. In addition, if we were to engage in certain hedging transactions, including hedging transactions in options, future contracts, and straddles, or other similar transactions, we could be subject to special tax rules (including constructive sale, mark-to-market, straddle, wash sale, and short sale rules), the effect of which may be to accelerate our income, defer our losses, cause adjustments in the holding periods of our securities, convert long-term capital gains into short-term capital gains or convert short-term capital losses into long-term capital losses. These rules could affect our investment company taxable income or net capital gain for a taxable year and thus affect the amounts that we would be required to distribute to our stockholders

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      Although we do not presently expect to do so, we are authorized to borrow funds and to sell assets in order to satisfy distribution requirements. However, under the 1940 Act, we are not permitted to make distributions to stockholders while our debt obligations and other senior securities are outstanding unless certain “asset coverage” tests are met. Moreover, our ability to dispose of assets to meet our distribution requirements may be limited by other requirements relating to our status as a regulated investment company, including the Diversification Tests. If we dispose of assets in order to meet the 90% Distribution Requirement or the Excise Tax Avoidance Requirements, we may make such dispositions at times that, from an investment standpoint, are not advantageous.

      If we fail to satisfy the 90% Distribution Requirement or otherwise fail to qualify as a regulated investment company in any taxable year, we will be subject to tax in that year on all of our taxable income, regardless of whether we make any distributions to our stockholders. In that case, all of our distributions to our stockholders will be characterized as ordinary income (to the extent of our current and accumulated earnings and profits). In contrast, as is explained below, if we qualify as a regulated investment company, a portion of our distributions or deemed distributions may be characterized as long-term capital gain in the hands of stockholders.

      The remainder of this summary assumes that we qualify as a regulated investment company and satisfy the 90% Distribution Requirement.

Taxation of Stockholders

      Our distributions generally are taxable to stockholders as ordinary income or capital gains. Our distributions of investment company taxable income will be taxable as ordinary income to stockholders to the extent of our current or accumulated earnings and profits, whether paid in cash or reinvested in additional common stock (including any dividends reinvested through our dividend reinvestment plan). Under new tax legislation, a portion of such distributions of investment company taxable income may constitute “qualified dividends” paid by us. Individual shareholders will incur a lower rate of tax on such qualified dividends than the rate of tax imposed on the remainder of our distributions of investment company taxable income. Our distributions of net capital gains properly designated by us as “capital gain dividends” will be taxable to each stockholder as long-term capital gains regardless of the stockholder’s holding period for his or her common stock and regardless of whether paid in cash or reinvested in additional common stock (including any dividends reinvested through our dividend reinvestment plan). Distributions in excess of the Company’s earnings and profits first will reduce a stockholder’s adjusted tax basis in such stockholder’s common stock and, after the adjusted basis is reduced to zero, will constitute capital gains to such stockholder.

      At our option, we may elect to retain some or all of our net capital gains for a tax year, but designate the retained amount as a “deemed distribution.” In that case, among other consequences, we will pay tax on the retained amount for the benefit of our stockholders, the stockholders will be required to report their share of the deemed distribution on their tax returns as if it had been distributed to them, and the stockholders will report a credit for the tax paid thereon by us. The amount of the deemed distribution net of such tax will be added to the stockholder’s cost basis for his or her common stock. Since we expect to pay tax on any retained net capital gains at our regular corporate capital gain tax rate, and since that rate is in excess of the maximum rate currently

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      Any dividend declared by us in October, November, or December of any calendar year, payable to stockholders of record on a specified date in such a month and actually paid during January of the following year, will be treated as if it had been received by the stockholders on December 31 of the year in which the dividend was declared.

      You should consider the tax implications of buying common stock just prior to a distribution. Even if the price of the common stock includes the amount of the forthcoming distribution, you may be taxed upon receipt of the distribution and will not be entitled to offset the distribution against the tax basis in your common stock.

      You may recognize taxable gain or loss if you sell or exchange your common stock. The amount of the gain or loss will be measured by the difference between your adjusted tax basis in your common stock and the amount of the proceeds you receive in exchange for such stock. Any gain or loss arising from (or, in the case of distributions in excess of earnings and profits, treated as arising from) the sale or exchange of common stock generally will be a capital gain or loss. This capital gain or loss normally will be treated as a long-term capital gain or loss if you have held your common stock for more than one year; otherwise, it will be classified as short-term capital gain or loss. However, any capital loss arising from the sale or exchange of common stock held for six months or less generally will be treated as a long-term capital loss to the extent of the amount of capital gain dividends received (or treated as deemed distributed) with respect to such stock and, for this purpose, the special rules of Section 852(b)(4)(C) of the Internal Revenue Code generally apply in determining the holding period of such stock. In addition, all or a portion of any loss realized upon a taxable disposition of common stock will be disallowed if other shares of our common stock are purchased (under our dividend reinvestment plan or otherwise) within 30 days before or after the disposition.

      In general, non-corporate stockholders currently are subject to a maximum federal income tax rate on their net long-term capital gain (the excess of net long-term capital gain over net short-term capital loss) for a taxable year (including a long-term capital gain derived from an investment in our common stock) that is lower than the maximum rate for other income (excluding other income that constitutes a “qualified dividend”). Corporate taxpayers currently are subject to federal income tax on net capital gains at a maximum rate equal to the maximum rate applied to ordinary income. Non-corporate stockholders with net capital losses for a year (i.e., capital losses in excess of capital gains) generally may deduct up to $3,000 of such losses against their ordinary income each year; any net capital losses of a non-corporate stockholder in excess of $3,000 generally may be carried forward and used in subsequent years as provided in Section 1212(b) of the Internal Revenue Code. Corporate stockholders generally may not deduct any net capital losses for a year, but may carryback such losses for three years or carry forward such losses for five years.

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      We will send to each of our stockholders, as promptly as possible after the end of each calendar year, a notice detailing, on a per share and per distribution basis, the amounts includible in such stockholder’s taxable income for such year as ordinary income (including the amount of any qualified dividends) and as long-term capital gain. In addition, the federal tax status of each year’s distributions generally will be reported to the IRS. Distributions may also be subject to additional state, local, and foreign taxes depending on a stockholder’s particular situation. Our ordinary income dividends to corporate stockholders may, if certain conditions are met, qualify for the dividends received deduction to the extent that we have received qualifying dividend income during the taxable year; capital gain dividends distributed by us are not eligible for the dividends received deduction.

      A Non-U.S. Stockholder may be subject to withholding of U.S. federal tax at a 30% rate (or lower applicable treaty rate) on distributions (including certain redemptions of common stock) from us. Accordingly, investment in us is likely to be appropriate for a Non-U.S. Stockholder only if such person can utilize a foreign tax credit or corresponding tax benefit in respect of such withholding tax. Non-U.S. Stockholders should consult their own tax advisors with respect to the U.S. federal income and withholding tax, and state, local, and foreign tax, consequences of an investment in our common stock.

      We may be required to withhold U.S. federal income tax (“backup withholding”) from all taxable distributions payable to (i) any stockholder who fails to furnish us with its correct taxpayer identification number or a certificate that the stockholder is exempt from backup withholding, and (ii) any stockholder with respect to whom the IRS notifies us that the stockholder has failed to properly report certain interest and dividend income to the IRS and to respond to notices to that effect. We may be required to report annually to the IRS and to each Non-U.S. Stockholder the amount of dividends paid to such stockholder and the amount, if any, of tax withheld pursuant to the backup withholding rules with respect to such dividends. This information may also be made available to the tax authorities in the Non-U.S. Stockholder’s country of residence. Backup withholding is not an additional tax. Any amounts withheld under the backup withholding rules from payments made to a stockholder may be refunded or credited against such stockholder’s United States federal income tax liability, if any, provided that the required information is furnished to the IRS.

      You should consult your own tax advisor with respect to the particular tax consequences to you of an investment in us, including the possible effect of any pending legislation or proposed regulation.

CERTAIN GOVERNMENT REGULATIONS

      We operate in a highly regulated environment. The following discussion generally summarizes certain government regulations.

      Business Development Company. A business development company is defined and regulated by the 1940 Act. A business development company must be organized in the United States for the purpose of investing in or lending to primarily private companies and making managerial assistance available to them. A business development company may use capital provided by public shareholders and from other sources to invest in long-term, private investments in businesses. A business development company provides shareholders the ability to retain the liquidity of a publicly traded stock, while sharing in the possible benefits, if any, of investing in primarily privately owned companies.

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      As a business development company, we may not acquire any asset other than “qualifying assets” unless, at the time we make the acquisition, the value of our qualifying assets represent at least 70% of the value of our total assets. The principal categories of qualifying assets relevant to our business are:

	•	Securities purchased in transactions not involving any public offering, the issuer of which is an eligible portfolio company;
	•	Securities received in exchange for or distributed with respect to securities described in the bullet above or pursuant to the exercise of options, warrants or rights relating to such securities; and
	•	Cash, cash items, government securities or high quality debt securities (within the meaning of the 1940 Act), maturing in one year or less from the time of investment.

      An eligible portfolio company is generally a domestic company that is not an investment company (other than a small business investment company wholly owned by a business development company, such as our investment in Allied Investment Corporation) and that:

	•	does not have a class of securities registered on an exchange or a class of securities with respect to which a broker may extend margin credit;
	•	is actively controlled by the business development company and has an affiliate of a business development company on its board of directors; or
	•	meets such other criteria as may be established by the SEC.

      Control under the 1940 Act is presumed to exist where a business development company beneficially owns more than 25% of the outstanding voting securities of the portfolio company.

      To include certain securities described above as qualifying assets for the purpose of the 70% test, a business development company must make available to the issuer of those securities significant managerial assistance such as providing significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company or making loans to a portfolio company. We offer to provide significant managerial assistance to each of our portfolio companies.

      As a business development company, we are entitled to issue senior securities in the form of stock or senior securities representing indebtedness, including debt securities and preferred stock, as long as each class of senior security has an asset coverage of at least 200% immediately after each such issuance. This limitation is not applicable to borrowings by our small business investment company subsidiary, and therefore any borrowings by this subsidiary are not included in this asset coverage test. See “Risk Factors.”

      We may also be prohibited under the 1940 Act from knowingly participating in certain transactions with our affiliates without the prior approval of our board of directors who are not interested persons and, in some cases, prior approval by the SEC. We have been granted an exemptive order by the SEC permitting us to engage in certain transactions that would be permitted if we and our subsidiaries were one company and permitting certain transactions among our subsidiaries, subject to certain conditions and limitations.

      We are periodically examined by the SEC for compliance with the 1940 Act.

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      As with other companies regulated by the 1940 Act, a business development company must adhere to certain substantive regulatory requirements. A majority of our directors must be persons who are not interested persons, as that term is defined in the 1940 Act. Additionally, we are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect us against larceny and embezzlement. Furthermore, as a business development company, we are prohibited from protecting any director or officer against any liability to the Company or our shareholders arising from willful malfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.

      We maintain a code of ethics that establishes procedures for personal investment and restricts certain transactions by our personnel. Our code of ethics generally does not permit investment by our employees in securities that may be purchased or held by us. The code of ethics is filed as an exhibit to our registration statement of which this prospectus is a part. You may read and copy the code of ethics at the SEC’s Public Reference Room in Washington, D.C. You may obtain information on operations of the Public Reference Room by calling the SEC at (202) 942-8090. In addition, the code of ethics is available on the EDGAR Database on the SEC Internet site at http://www.sec.gov. You may obtain copies of the code of ethics, after paying a duplicating fee, by electronic request at the following email address: publicinfo@sec.gov, or by writing to the SEC’s Public Reference Section, 450 5th Street, NW, Washington, D.C. 20549.

      As a business development company under the 1940 Act, we are entitled to provide loans to our employees in connection with the exercise of options. However, as a result of provisions of the Sarbanes-Oxley Act of 2002, we are prohibited from making new loans to, or materially modifying existing loans with, our executive officers in the future.

      We may not change the nature of our business so as to cease to be, or withdraw our election as, a business development company unless authorized by vote of a “majority of the outstanding voting securities,” as defined in the 1940 Act, of our shares. A majority of the outstanding voting securities of a company is defined under the 1940 Act as the lesser of: (i) 67% or more of such company’s shares present at a meeting if more than 50% of the outstanding shares of such company are present and represented by proxy or (ii) more than 50% of the outstanding shares of such company. Since we made our business development company election, we have not made any substantial change in the nature of our business.

      Small Business Administration Regulations. Allied Investment Corporation, a wholly owned subsidiary of Allied Capital, is licensed by the Small Business Administration as a small business investment company under Section 301(c) of the Small Business Investment Act of 1958, and has elected to be regulated as a business development company.

      Small business investment companies are authorized to stimulate the flow of private equity capital to eligible small businesses. Under present Small Business Administration regulations, eligible small businesses include businesses that have a net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the two most recent fiscal years. In addition, a small business investment company must devote 20% of its investment activity to “smaller” concerns as defined by the Small Business Administration. A smaller concern is one that has a net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the two most recent fiscal years. Small Business Administration regulations also provide alternative size standard criteria to determine eligibility, which depend on the

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      Allied Investment is periodically examined and audited by the Small Business Administration’s staff to determine its compliance with small business investment company regulations.

      We, through Allied Investment, 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. Under the small business investment company program, we may borrow up to $113.4 million from the Small Business Administration. At December 31, 2002, the Small Business Administration has a commitment to lend up to an additional $7.3 million above the amount outstanding. The commitment expires on September 30, 2005.

      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. As long as we qualify as a regulated investment company, we are not taxed on our investment company taxable income or realized capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to shareholders on a timely basis. Annual tax distributions generally differ from net income for the fiscal year due to temporary and permanent timing differences in the recognition of income and expenses, returns of capital and net unrealized appreciation or depreciation, which are not included in taxable income.

      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 investment diversification requirements as defined in the Internal Revenue Code; and (4) distribute annually to shareholders at least 90% of our investment company taxable income as defined in the Internal Revenue 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.

      Compliance with the Sarbanes-Oxley Act of 2002 and NYSE Corporate Governance Regulations. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”). The Sarbanes-Oxley Act imposes a wide variety of new regulatory requirements on publicly-held companies and their insiders. Many of these requirements will affect us. For example:

	•	Our chief executive officer and chief financial officer must now certify the accuracy of the financial statements contained in our periodic reports;
	•	Our periodic reports must disclose our conclusions about the effectiveness of our disclosure controls and procedures;
	•	Our periodic reports must disclose whether there were significant changes in our internal controls or in other factors that could significantly affect these controls

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		subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses; and
	•	We may not make any loan to any director or executive officer and we may not materially modify any existing loans.

      The Sarbanes-Oxley Act has required us to review our current policies and procedures to determine whether we comply with the Sarbanes-Oxley Act and the new regulations promulgated thereunder. We will continue to monitor our compliance with all future regulations that are adopted under the Sarbanes-Oxley Act and will take actions necessary to ensure that we are in compliance therewith.

      In addition, the New York Stock Exchange has proposed corporate governance changes to its listing standards. These new rules become effective after review and approval by the SEC. Some proposed corporate governance changes will become effective immediately upon approval by the SEC, while others require compliance after specified periods, ranging from six months to two years after approval by the SEC.

      We have begun to review our current policies and procedures to determine whether we comply with the New York Stock Exchange’s proposed corporate governance rules. We will continue to monitor our compliance with all future listing standards that are approved by the SEC and will take actions necessary to ensure that we are in compliance therewith.

DIVIDEND REINVESTMENT PLAN

      We currently maintain a dividend reinvestment plan that provides for reinvestment of our distributions on behalf of our shareholders by our transfer agent. Effective May 1, 2002, the dividend reinvestment plan was converted from an “opt out” to an “opt in” plan. As a result, if our board of directors declares a cash dividend, then our new shareholders that have not “opted in” to our dividend reinvestment plan will receive cash dividends, rather than reinvesting dividends in additional shares of common stock. Existing dividend reinvestment plan accounts will not be affected by this amendment and no existing instructions, either to receive cash dividends or to reinvest dividends, will be changed.

      To enroll in the dividend reinvestment plan, each shareholder must complete an enrollment status form and return it to the plan agent. The plan agent shall then automatically reinvest any dividend in additional shares of common stock. You may change your status in the dividend reinvestment plan at any time by contacting our transfer agent and plan administrator in writing.

      A shareholder’s ability to participate in a dividend reinvestment plan may be limited according to how the shares of common stock are held. A nominee may preclude beneficial owners holding shares in street name from participating in the dividend reinvestment plan. Shareholders who wish to participate in a dividend reinvestment plan may need to hold their shares of common stock in their own name. Shareholders will be informed of their right to opt into the dividend reinvestment plan in our annual and quarterly reports to shareholders. Shareholders who hold shares in the name of a nominee should contact the nominee for details.

      All distributions to investors who do not participate (or whose nominee elects not to participate) in the dividend reinvestment plan will be paid directly, or through the nominee, to the record holder by or under the discretion of the plan agent. The plan agent is American Stock Transfer and Trust Company, 59 Maiden Lane, New York, New York 10038. Their telephone number is (800) 937-5449.

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      Under the dividend reinvestment plan, we may issue new shares unless the market price of the outstanding shares of common stock is less than 110% of the last reported net asset value. Alternatively, the plan agent may buy shares of common stock in the market. We value newly issued shares of common stock for the dividend reinvestment plan at the average of the reported last sale prices of the outstanding shares of common stock on the last five trading days prior to the payment date of the distribution, but not less than 95% of the opening bid price on such date. The price in the case of shares bought in the market will be the average actual cost of such shares of common stock, including any brokerage commissions. There are no other fees charged to shareholders in connection with the dividend reinvestment plan. Any distributions reinvested under the plan will nevertheless remain taxable to the shareholders.

DESCRIPTION OF CAPITAL STOCK

      The following summary of our capital stock does not purport to be complete and is subject to, and qualified in its entirety by, our Restated Articles of Incorporation, which we sometimes refer to as our charter. Reference is made to the charter for a detailed description of the provisions summarized below.

      Our authorized capital stock is 200,000,000 shares, $0.0001 par value. Our board of directors may classify and reclassify any unissued shares of our capital stock by setting or changing in one or more respects the preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications, terms or conditions or redemption or other rights of such shares of capital stock.

Common Stock

      At June 4, 2003, there were 113,162,545 shares of common stock outstanding and 9,414,604 shares of common stock reserved for issuance under our amended stock option plan. The following are the outstanding classes of securities of Allied Capital as of June 4, 2003:

(4)

(3)

Amount

Amount Held

Outstanding

(2)

by Us

Exclusive of

(1)

Amount

or for Our

Amounts Shown

Title of Class

Authorized

Account

Under(3)

Allied Capital Corporation

Common Stock

200,000,000

—

113,162,545

      All shares of common stock have equal rights as to earnings, assets, dividends and voting privileges and all outstanding shares of common stock are fully paid and non-assessable. Distributions may be paid to the holders of common stock if and when declared by our board of directors out of funds legally available therefor. Our common stock has no preemptive, conversion, or redemption rights and is freely transferable. In the event of liquidation, each share of common stock is entitled to share ratably in all of our assets that are legally available for distributions after payment of all debts and liabilities and subject to any prior rights of holders of preferred stock, if any, then outstanding. Each share of common stock is entitled to one vote and does not have cumulative voting rights, which means that holders of a majority of the shares, if they so choose, could elect all of the directors, and holders of less than a majority of the shares would, in that case, be unable

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Limitation on Liability of Directors

      We have adopted provisions in our charter limiting the liability of our directors and officers for monetary damages. The effect of these provisions in the charter is to eliminate the rights of Allied Capital and its shareholders (through shareholders’ derivative suits on our behalf) to recover monetary damages against a director or officer for breach of the fiduciary duty of care as a director or officer (including breaches resulting from negligent or grossly negligent behavior) except for liability resulting from (i) actual receipt of an improper benefit or profit in money, property or services or (ii) acts committed in bad faith or active and deliberate dishonesty established by a final judgment as being material to the cause of action. These provisions do not limit or eliminate the rights of Allied Capital or any shareholder to seek non-monetary relief such as an injunction or rescission in the event of a breach of a director’s or officer’s duty of care. These provisions will not alter the liability of directors or officers under federal securities laws.

Certain Anti-Takeover Provisions

      Our charter and bylaws and certain statutory and regulatory requirements contain certain provisions that could make more difficult the acquisition of Allied Capital by means of a tender offer, a proxy contest or otherwise. These provisions are expected to discourage certain types of coercive takeover practices and inadequate takeover bids and to encourage persons seeking to acquire control of us to negotiate first with the board of directors. We believe that the benefits of these provisions outweigh the potential disadvantages of discouraging such proposals because, among other things, negotiation of such proposals might result in an improvement of their terms. The description set forth below is intended only to be a summary of certain of our anti-takeover provisions and is qualified in its entirety by reference to our charter and the bylaws.

Classified Board of Directors

     Our charter provides for our Board of Directors to be divided into three classes of directors serving staggered three-year terms, with each class to consist as nearly as possible of one-third of the directors then elected to the board. A classified board may render more difficult a change in control of Allied Capital or removal of incumbent management. We believe, however, that the longer time required to elect a majority of a classified Board of Directors helps to ensure continuity and stability of our management and policies.

Issuance of Preferred Stock

     Our board of directors, without shareholder approval, has the authority to reclassify authorized but unissued common stock as preferred stock and to issue preferred stock. Such stock could be issued with voting, conversion or other rights designed to have an anti-takeover effect.

Maryland Corporate Law

     We are subject to the Maryland Business Combination Statute and the Control Share Acquisition Statute, as defined below. The partial summary of the foregoing statutes

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      Business Combination Statute. Certain provisions of the Maryland General Corporation Law establish special requirements with respect to “business combinations” between Maryland corporations and “interested shareholders” unless exemptions are applicable (the “Business Combination Statute”). Among other things, the Business Combination Statute prohibits for a period of five years a merger or other specified transactions between a company and an interested shareholder and requires a supermajority vote for such transactions after the end of such five-year period.

      “Interested shareholders” are all persons owning beneficially, directly or indirectly, 10% or more of the outstanding voting stock of a Maryland corporation. “Business combinations” include certain mergers or similar transactions subject to a statutory vote and additional transactions involving transfer of assets or securities in specified amounts to interested shareholders or their affiliates.

      Unless an exemption is available, a “business combination” may not be consummated between a Maryland corporation and an interested shareholder or its affiliates for a period of five years after the date on which the shareholder first became an interested shareholder and thereafter may not be consummated unless recommended by the board of directors of the Maryland corporation and approved by the affirmative vote of at least 80% of the votes entitled to be cast by all holders of outstanding shares of voting stock and 66 2/3% of the votes entitled to be cast by all holders of outstanding shares of voting stock other than the interested shareholder or its affiliates or associates, unless, among other things, the corporation’s shareholders receive a minimum price (as defined in the Business Combination Statute) for their shares and the consideration is received in cash or in the same form as previously paid by the interested shareholder for its shares.

      A business combination with an interested shareholder which is approved by the board of directors of a Maryland corporation at any time before an interested shareholder first becomes an interested shareholder is not subject to the five-year moratorium or special voting requirements. An amendment to a Maryland corporation’s charter electing not to be subject to the foregoing requirements must be approved by the affirmative vote of at least 80% of the votes entitled to be cast by all holders of outstanding shares of voting stock and 66 2/3% of the votes entitled to be cast by holders of outstanding shares of voting stock who are not interested shareholders. Any such amendment is not effective until 18 months after the vote of shareholders and does not apply to any business combination of a corporation with a shareholder who became an interested shareholder on or prior to the date of such vote.

      Control Share Acquisition Statute. The Maryland General Corporation Law imposes limitations on the voting rights of shares acquired in a “control share acquisition.” The control share statute defines a “control share acquisition” to mean the acquisition, directly or indirectly, of “control shares” subject to certain exceptions. “Control shares” of a Maryland corporation are defined to be voting shares of stock which, if aggregated with all other shares of stock previously acquired by the acquiror, would entitle the acquiror to exercise voting power in electing directors with one of the following ranges of voting power:

	(1)	one-tenth or more but less than one-third;

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	(2)	one-third or more but less than a majority; or
	(3)	a majority of all voting power.

      Control shares do not include shares which the acquiring person is entitled to vote as a result of having previously obtained shareholder approval. Control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast by shareholders in the election of directors, excluding shares of stock as to which the acquiring person, officers of the corporation and directors of the corporation who are employees of the corporation are entitled to exercise or direct the exercise of the voting power of the shares in the election of the directors.

      The control share statute also requires Maryland corporations to hold a special meeting at the request of an actual or proposed control share acquiror generally within 50 days after a request is made with the submission of an “acquiring person statement,” but only if the acquiring person:

	(1)	gives a written undertaking and, if required by the directors of the issuing corporation, posts a bond for the cost of the meeting; and
	(2)	submits definitive financing agreements for the acquisition of the control shares to the extent that financing is not provided by the acquiring person.

      In addition, unless the issuing corporation’s charter or bylaws provide otherwise, the control share statute provides that the issuing corporation, within certain time limitations, shall have the right to redeem control shares (except those for which voting rights have previously been approved) for “fair value” as determined pursuant to the control share statute in the event:

	(1)	there is a shareholder vote and the grant of voting rights is not approved; or
	(2)	an “acquiring person statement” is not delivered to the target within 10 days following a control share acquisition.

      Moreover, unless the issuing corporation’s charter or bylaws provide otherwise, the control share statute provides that if, before a control share acquisition occurs, voting rights are accorded to control shares which result in the acquiring person having majority voting power, then all shareholders other than the acquiring person have appraisal rights as provided under the Maryland General Corporation Law. An acquisition of shares may be exempted from the control share statute provided that a charter or bylaw provision is adopted for such purpose prior to the control share acquisition by any person with respect to Allied Capital. The control share acquisition statute does not apply to shares acquired in a merger, consolidation or share exchange to which the corporation is a party.

Regulatory Restrictions

     Allied Investment, our wholly owned subsidiary, is a small business investment company. The Small Business Administration prohibits, without prior Small Business Administration approval, a “change of control” or transfers which would result in any person (or group of persons acting in concert) owning 10% or more of any class of capital stock of a small business investment company. A “change of control” is any event which would result in a transfer of the power, direct or indirect, to direct the management and

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PLAN OF DISTRIBUTION

      We may offer, from time to time, up to 18,000,000 shares of our common stock. We may sell the shares of our common stock through underwriters or dealers, directly to one or more purchasers, through agents or through a combination of any such methods of sale. Any underwriter or agent involved in the offer and sale of the shares of our common stock will be named in the applicable prospectus supplement.

      The distribution of the shares of our common stock may be effected from time to time in one or more transactions at a fixed price or prices, which may be changed, at prevailing market prices at the time of sale, at prices related to such prevailing market prices, or at negotiated prices, provided, however, that the offering price per share of our common stock, less any underwriting commissions or discounts, must equal or exceed the net asset value per share of our common stock at the time of the offering.

      In connection with the sale of the shares of our common stock, underwriters or agents may receive compensation from us or from purchasers of the shares of our common stock, for whom they may act as agents, in the form of discounts, concessions or commissions. Underwriters may sell shares of our common stock to or through dealers and such dealers may receive compensation in the form of discounts, concessions or commissions from the underwriters and/or commissions from the purchasers for whom they may act as agents. Underwriters, dealers and agents that participate in the distribution of shares of our common stock may be deemed to be underwriters under the Securities Act, and any discounts and commissions they receive from us and any profit realized by them on the resale of shares of our common stock may be deemed to be underwriting discounts and commissions under the Securities Act. Any such underwriter or agent will be identified and any such compensation received from us will be described in the applicable prospectus supplement.

      Any common stock sold pursuant to a prospectus supplement will be quoted on the New York Stock Exchange, or another exchange on which the common stock is traded.

      Under agreements into which we may enter, underwriters, dealers and agents who participate in the distribution of shares of our common stock may be entitled to indemnification by us against certain liabilities, including liabilities under the Securities Act. Underwriters, dealers and agents may engage in transactions with, or perform services for, us in the ordinary course of business.

      If so indicated in the applicable prospectus supplement, we will authorize underwriters or other persons acting as our agents to solicit offers by certain institutions to purchase shares of our common stock from us pursuant to contracts providing for payment and delivery on a future date. Institutions with which such contracts may be made include commercial and savings banks, insurance companies, pension funds, investment companies, educational and charitable institutions and others, but in all cases such institutions must be approved by us. The obligations of any purchaser under any such contract will be subject to the condition that the purchase of shares of our common stock shall not at the time of delivery be prohibited under the laws of the jurisdiction to which such purchaser is subject. The underwriters and such other agents will not have any responsibility in respect of the validity or performance of such contracts. Such contracts will be subject only to those

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      The maximum commission or discount to be received by any member of the National Association of Securities Dealers, Inc. or independent broker-dealer will not be greater than 10% for the sale of any securities being registered and .5% for due diligence.

      In order to comply with the securities laws of certain states, if applicable, shares of our common stock offered hereby will be sold in such jurisdictions only through registered or licensed brokers or dealers.

LEGAL MATTERS

      The legality of shares of our common stock offered hereby will be passed upon for us by Sutherland Asbill & Brennan LLP, Washington, D.C. Certain legal matters will be passed upon for underwriters, if any, by the counsel named in the prospectus supplement.

SAFEKEEPING, TRANSFER AND DIVIDEND PAYING AGENT

      Our investments are held in safekeeping by Riggs Bank, N.A. at 808 17th Street, N.W., Washington, D.C. 20006, as well as by LaSalle National Bank, located at 25 Northwest Point Boulevard, Suite 800, Elk Grove Village, Illinois 60007. American Stock Transfer and Trust Company, 59 Maiden Lane, New York, New York 10038 acts as our transfer, dividend paying and reinvestment plan agent and registrar.

BROKERAGE ALLOCATION AND OTHER PRACTICES

      Since we generally acquire and dispose of our investments in privately negotiated transactions, we infrequently use brokers in the normal course of business.

INDEPENDENT PUBLIC ACCOUNTANTS

      The audited consolidated financial statements and schedules as of December 31, 2002, and for the year then ended, have been included herein in reliance upon the reports of KPMG LLP, independent accountants, appearing elsewhere herein, and upon the authority of said firm as experts in accounting and auditing.

      The audited financial statements and schedules included in this prospectus and elsewhere in the registration statement to the extent and for the periods indicated in their report have been audited by Arthur Andersen LLP, independent public accountants. For important information about Arthur Andersen LLP, see “Notice Regarding Arthur Andersen LLP” below.

      On March 29, 2002, we selected KPMG LLP to serve as our independent public accountants for the fiscal year ending December 31, 2002. We dismissed Arthur Andersen LLP as our independent accountants effective upon completion of the December 31, 2001 audit. The decision to change accountants was approved by our Audit Committee and Board of Directors and was ratified by our stockholders on May 7, 2002.

      In connection with the audits for the 2001 and 2000 fiscal years and through April 3, 2002, (1) there were no disagreements with Arthur Andersen LLP on any matter of

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      The reports of Arthur Andersen LLP on our financial statements for fiscal years ended December 31, 2001 and 2000 contained no adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principle, except for the emphasis of matter related to the inherent uncertainty of determining the value of investments whose values have been determined by the Board of Directors in good faith in the absence of readily ascertainable market values.

      We had not consulted with KPMG LLP during 2001 or 2000 or the period from January 1, 2002 through March 29, 2002, on either the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion KPMG LLP might issue on our financial statements.

NOTICE REGARDING ARTHUR ANDERSEN LLP

      Section 11(a) of the Securities Act provides that if any part of a registration statement at the time it becomes effective contains an untrue statement of a material fact or an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring a security pursuant to such registration statement, unless it is proved that at the time of such acquisition such person knew of such untruth or omission, may sue, among others, every accountant who has consented to be named as having prepared or certified any part of the registration statement or as having prepared or certified any report or valuation which is used in connection with the registration statement with respect to the statement in such registration statement, report or valuation which purports to have been prepared or certified by the accountant.

      Our consolidated financial statements as of December 31, 2001 and 2000 and for each of the two years in the two-year period ended December 31, 2001 included in this prospectus were audited by our former independent auditor, Arthur Andersen LLP. However, we have not been able to obtain, after reasonable efforts, the written consent of Arthur Andersen LLP with respect to the inclusion of such consolidated financial statements in this prospectus. Under these circumstances, Rule 437a under the Securities Act permits us to file this registration statement without a consent of Arthur Andersen LLP. As a result, you will not be able to sue Arthur Andersen LLP pursuant to Section 11(a) of the Securities Act and therefore your right of recovery under that section may be limited as a result of the lack of the written consent.

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

		Page
Consolidated Balance Sheet — December 31, 2002 and 2001			F-2
Consolidated Statement of Operations — For the Years Ended December 31, 2002, 2001, and 2000			F-3
Consolidated Statement of Changes in Net Assets — For the Years Ended December 31, 2002, 2001, and 2000			F-4
Consolidated Statement of Cash Flows — For the Years Ended December 31, 2002, 2001, and 2000			F-5
Consolidated Statement of Investments — December 31, 2002			F-6
Notes to Consolidated Financial Statements			F-17
Reports of Independent Public Accountants			F-47

F-1

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

					December 31,
					2002				2001
(in thousands, except share and per share amounts)
ASSETS
Portfolio at value:
	Private finance
		Companies more than 25% owned (cost: 2002-$628,535; 2001-$448,797)			$	710,587			$	504,657
		Companies 5% to 25% owned (cost: 2002-$219,124; 2001-$226,020)				255,677				245,561
		Companies less than 5% owned (cost: 2002-$863,243; 2001-$879,149)				776,951				844,854
			Total private finance			1,743,215				1,595,072
	Commercial real estate finance (cost: 2002-$718,312; 2001-$732,636)					744,952				734,518
			Total portfolio at value			2,488,167				2,329,590
Deposits of proceeds from sales of borrowed Treasury securities						194,745				48,504
Other assets						100,221				81,730
Cash and cash equivalents						11,186				889
			Total assets		$	2,794,319			$	2,460,713
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
	Notes payable and debentures				$	794,200			$	876,056
	Revolving line of credit					204,250				144,750
	Obligations to replenish borrowed Treasury securities					197,027				47,263
	Accounts payable and other liabilities					45,771				33,521
			Total liabilities			1,241,248				1,101,590
Commitments and contingencies
Preferred stock						7,000				7,000
Shareholders’ equity:
	Common stock, $0.0001 par value, 200,000,000 shares authorized; 108,698,409 and 99,607,396 shares issued and outstanding at December 31, 2002 and 2001, respectively					11				10
	Additional paid-in capital					1,547,183				1,352,688
	Notes receivable from sale of common stock					(24,704	)			(26,028	)
	Net unrealized appreciation on portfolio					39,411				39,981
	Distributions in excess of earnings					(15,830	)			(14,528	)
			Total shareholders’ equity			1,546,071				1,352,123
			Total liabilities and shareholders’ equity		$	2,794,319			$	2,460,713
Net asset value per common share					$	14.22			$	13.57

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

F-2

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF OPERATIONS

					For the Years Ended December 31,
					2002				2001				2000
(in thousands, except per share amounts)
Interest and related portfolio income
	Interest and dividends
		Companies more than 25% owned			$	40,185			$	25,264			$	3,077
		Companies 5% to 25% owned				28,629				27,656				17,194
		Companies less than 5% owned				195,228				187,544				162,036
			Total interest and dividends			264,042				240,464				182,307
	Premiums from loan dispositions
		Companies more than 25% owned				—				1,011				—
		Companies 5% to 25% owned				200				400				380
		Companies less than 5% owned				2,576				1,093				15,758
			Total premiums from loan dispositions			2,776				2,504				16,138
	Fees and other income
		Companies more than 25% owned				25,344				24,817				2,000
		Companies 5% to 25% owned				1,123				230				205
		Companies less than 5% owned				16,643				21,095				10,939
			Total fees and other income			43,110				46,142				13,144
			Total interest and related portfolio income			309,928				289,110				211,589
Expenses
	Interest					70,443				65,104				57,412
	Employee					33,126				29,656				26,025
	Administrative					21,504				15,299				15,435
			Total operating expenses			125,073				110,059				98,872
Net investment income before income taxes and net realized and unrealized gains						184,855				179,051				112,717
Income tax expense (benefit)						930				(412	)			—
Net investment income before net realized and unrealized gains						183,925				179,463				112,717
Net Realized and Unrealized Gains
Net realized gains (losses)
		Companies more than 25% owned				58,444				1,893				—
		Companies 5% to 25% owned				866				1,639				(54	)
		Companies less than 5% owned				(14,373	)			(2,871	)			15,577
			Total net realized gains			44,937				661				15,523
	Net unrealized gains (losses)					(571	)			20,603				14,861
			Total net realized and unrealized gains			44,366				21,264				30,384
Net increase in net assets resulting from operations					$	228,291			$	200,727			$	143,101
Basic earnings per common share					$	2.23			$	2.19			$	1.95
Diluted earnings per common share					$	2.20			$	2.16			$	1.94
Weighted average common shares outstanding — basic						102,107				91,564				73,165
Weighted average common shares outstanding — diluted						103,574				93,003				73,472

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

F-3

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS

				For the Years Ended December 31,
				2002				2001				2000
(in thousands, except per share amounts)
Operations
	Net investment income before net realized and unrealized gains			$	183,925			$	179,463			$	112,717
	Net realized gains				44,937				661				15,523
	Net unrealized gains (losses)				(571	)			20,603				14,861
		Net increase in net assets resulting from operations			228,291				200,727				143,101
Shareholder distributions
	Common stock dividends				(229,935	)			(186,157	)			(135,795	)
	Preferred stock dividends				(230	)			(230	)			(230	)
		Net decrease in net assets resulting from shareholder distributions			(230,165	)			(186,387	)			(136,025	)
Capital share transactions
	Sale of common stock				172,847				286,888				250,912
	Issuance of common stock for portfolio investments				—				5,157				86,076
	Issuance of common stock upon the exercise of stock options				14,517				10,660				3,309
	Issuance of common stock in lieu of cash distributions				6,263				6,331				4,773
	Net decrease (increase) in notes receivable from sale of common stock				1,324				(945	)			4,378
	Net decrease in common stock held in deferred compensation trust				—				—				6,218
	Other				871				—				(563	)
		Net increase in net assets resulting from capital share transactions			195,822				308,091				355,103
		Total increase in net assets		$	193,948			$	322,431			$	362,179
Net assets at beginning of year					1,352,123				1,029,692				667,513
Net assets at end of year				$	1,546,071			$	1,352,123			$	1,029,692
Net asset value per common share				$	14.22			$	13.57			$	12.11
Common shares outstanding at end of year					108,698				99,607				85,057

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

F-4

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

					For the Years Ended December 31,
					2002				2001				2000
(in thousands)
Cash flows from operating activities
	Net increase in net assets resulting from operations				$	228,291			$	200,727			$	143,101
	Adjustments
		Portfolio investments				(506,376	)			(675,172	)			(827,025	)
		Repayments of investment principal				143,167				74,461				111,031
		Proceeds from investment sales				213,474				129,980				280,244
		Change in accrued or reinvested interest and dividends				(44,665	)			(51,554	)			(32,245	)
		Amortization of discounts and fees				(20,592	)			(13,929	)			(10,101	)
		Changes in other assets and liabilities				(735	)			1,290				3,472
		Depreciation and amortization				1,572				994				925
		Realized losses				50,625				9,446				13,081
		Net unrealized losses (gains)				571				(20,603	)			(14,861	)
			Net cash provided by (used in) operating activities			65,332				(344,360	)			(332,378	)
Cash flows from financing activities
	Sale of common stock					172,847				286,888				250,912
	Sale of common stock upon the exercise of stock options					12,136				5,428				319
	Collections of notes receivable from sale of common stock					3,706				5,090				6,363
	Common dividends and distributions paid					(220,411	)			(179,826	)			(131,022	)
	Preferred stock dividends paid					(230	)			(230	)			(230	)
	Borrowings under notes payable and debentures					—				175,500				234,598
	Repayments on notes payable and debentures					(81,856	)			(9,350	)			(17,300	)
	Net borrowings under (repayments on) revolving line of credit					59,500				62,750				(23,500	)
	Other					(727	)			(3,450	)			(3,468	)
			Net cash provided by (used in) financing activities			(55,035	)			342,800				316,672
Net increase (decrease) in cash and cash equivalents					$	10,297			$	(1,560	)		$	(15,706	)
Cash and cash equivalents at beginning of year						889				2,449				18,155
Cash and cash equivalents at end of year					$	11,186			$	889			$	2,449

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

F-5

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF INVESTMENTS

Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Companies More Than 25% Owned
Acme Paging, L.P.			Loan		$	3,750			$	3,750
	(Telecommunications)		Equity Interests			13,274				9,223
			Common Stock (177 shares)			27				27
American Healthcare Services, Inc.			Loan			22,601				22,601
	(Healthcare)		Debt Securities			18,061				15,891
			Common Stock (79,567,042 shares)			1,000				—
			Guaranty ($1,967)
Avborne, Inc.			Loan			9,625				9,625
	(Business Services)		Preferred Stock (12,500 shares)			14,138				2,300
			Common Stock (27,500 shares)			—				—
Business Loan Express, Inc.			Debt Securities			91,690				91,690
	(Financial Services)		Preferred Stock (25,111 shares)			25,111				25,111
			Common Stock (25,503,043 shares)			104,641				140,000
			Guaranty ($51,641 — See Note 3)
			Standby Letters of Credit ($10,550 — See Note 3)
The Color Factory, Inc.			Loan			9,589				9,589
	(Consumer Products)		Preferred Stock (1,000 shares)			1,002				1,002
			Common Stock (980 shares)			6,535				6,535
Elmhurst Consulting, LLC			Loan			15,747				15,100
	(Business Services)		Equity Interests			5,165				—
Foresite Towers, LLC			Equity Interests			15,522				13,775
	(Tower Leasing)
Gordian Group, Inc.			Loan			7,390				7,390
	(Business Services)		Common Stock (1,000 shares)			2,088				2,600
HealthASPex, Inc.			Preferred Stock (1,000,000 shares)			700				700
	(Business Services)		Preferred Stock (1,451,380 shares)			4,900				2,617
			Common Stock (1,451,380 shares)			4				—
The Hillman Companies, Inc.(1)			Debt Securities			41,980				41,980
	(Consumer Products)		Common Stock (6,890,937 shares)			50,645				138,488
HMT, Inc.			Debt Securities			9,081				9,081
	(Business Services)		Preferred Stock (554,052 shares)			2,216				2,216
			Common Stock (300,000 shares)			3,000				3,000
			Warrants			1,155				1,155

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-6

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Housecall Medical Resources, Inc.			Loan		$	14,928			$	14,928
	(Healthcare)		Preferred Stock (3,890,344 shares)			3,889				3,889
			Common Stock (864,000 shares)			86				86
Litterer Beteiligungs-GmbH(3)			Debt Securities			1,286				1,286
	(Business Services)		Equity Interest			358				358
MVL Group, Inc.			Loan			19,450				18,967
	(Business Services)		Debt Securities			16,270				16,270
			Common Stock (648,661 shares)			—				—
Powell Plant Farms, Inc.			Loan			24,964				24,964
	(Consumer Products)		Debt Securities			19,224				9,709
			Preferred Stock (1,483 shares)			—				—
			Warrants			—				—
Redox Brands, Inc.			Loan			3,000				3,000
	(Consumer Products)		Debt Securities			9,842				9,842
			Preferred Stock (2,404,086 shares)			6,965				6,965
			Warrants			584				1,450
Staffing Partners Holding			Debt Securities			6,304				6,304
	Company, Inc.		Preferred Stock (439,600 shares)			4,968				3,807
	(Business Services)		Common Stock (50,200 shares)			50				—
			Warrants			10				—
STS Operating, Inc.			Preferred Stock (5,769,424 shares)			6,525				6,525
	(Industrial Products)		Common Stock (3,000,000 shares)			3,177				3,177
Sure-Tel, Inc.			Preferred Stock (1,000,000 shares)			1,000				1,000
	(Consumer Services)		Common Stock (37,000 shares)			5,018				2,614
Total companies more than 25% owned					$	628,535			$	710,587
Companies 5% to 25% Owned
Aspen Pet Products, Inc.			Loans		$	16,625			$	16,625
	(Consumer Products)		Preferred Stock (2,024 shares)			2,024				2,024
			Common Stock (1,400 shares)			140				140
Autania AG(1,3)			Common Stock (250,000 shares)			2,169				2,477
	(Industrial Products)
Border Foods, Inc.			Debt Securities			9,383				9,383
	(Consumer Products)		Preferred Stock (50,919 shares)			2,000				2,000
			Warrants			665				665
CBA-Mezzanine Capital Finance, LLC			Loan			3,949				3,949
	(Financial Services)
CorrFlex Graphics, LLC			Debt Securities			11,951				11,951
	(Business Services)		Warrants			—				19,332
			Options			—				1,669

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-7

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
CyberRep			Loan		$	1,264			$	1,264
	(Business Services)		Debt Securities			14,868				14,868
			Warrants			660				8,236
The Debt Exchange Inc.			Preferred Stock (921,875 shares)			1,250				1,250
	(Business Services)
EDM Consulting, LLC			Debt Securities			1,802				286
	(Business Services)		Equity Interests			250				—
International Fiber Corporation			Debt Securities			22,606				22,606
	(Industrial Products)		Common Stock (1,029,069 shares)			5,483				6,816
			Warrants			550				684
Liberty-Pittsburgh Systems, Inc.			Debt Securities			3,500				3,500
	(Business Services)		Common Stock (123,929 shares)			142				67
Logic Bay Corporation			Preferred Stock (1,131,222 shares)			5,000				—
	(Business Services)
Magna Card, Inc.			Debt Securities			153				153
	(Consumer Products)		Preferred Stock (1,875 shares)			94				94
			Common Stock (4,687 shares)			—				—
Master Plan, Inc.			Loan			959				959
	(Business Services)		Common Stock (156 shares)			42				650
MortgageRamp, Inc.			Common Stock (772,000 shares)			3,860				3,860
	(Business Services)
Morton Grove Pharmaceuticals,			Loan			16,356				16,356
	Inc.		Preferred Stock (106,947 shares)			6,098				14,526
	(Consumer Products)
Nobel Learning Communities,			Debt Securities			9,755				9,755
	Inc.(1)		Preferred Stock (1,063,830 shares)			2,000				2,000
	(Education)		Warrants			575				245
Packaging Advantage Corporation			Debt Securities			14,234				14,234
	(Business Services)		Common Stock (232,168 shares)			2,386				2,386
			Warrants			963				963
Professional Paint, Inc.			Debt Securities			22,791				22,791
	(Consumer Products)		Preferred Stock (15,000 shares)			19,534				19,534
			Common Stock (110,000 shares)			69				5,000
Progressive International			Debt Securities			3,968				3,968
	Corporation		Preferred Stock (500 shares)			500				500
	(Consumer Products)		Common Stock (197 shares)			13				13
			Warrants			—				—
Prosperco Finanz Holding AG(3)			Convertible Debentures			7,166				7,166
	(Financial Services)		Common Stock (1,528 shares)			1,059				608
			Warrants			—				—

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-8

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Total Foam, Inc.			Debt Securities		$	258			$	124
	(Industrial Products)		Common Stock (164 shares)			10				—
Total companies 5% to 25% owned					$	219,124			$	255,677
Companies Less Than 5% Owned
ACE Products, Inc.			Loans		$	17,164			$	12,969
	(Industrial Products)
Advantage Sales and Marketing,			Debt Securities			10,603				10,603
	Inc.		Warrants			382				1,455
	(Business Services)
Alderwoods Group, Inc.(1)			Common Stock (357,568 shares)			5,006				1,695
	(Consumer Services)
Allied Office Products, Inc.			Common Stock (31,333 shares)			7,695				50
	(Business Services)
American Barbecue & Grill, Inc.			Warrants			125				—
	(Retail)
ASW Holding Corporation			Warrants			25				25
	(Industrial Products)
Bakery Chef, Inc.			Loans			18,213				18,213
	(Consumer Products)
Blue Rhino Corporation(1)			Debt Securities			14,018				14,018
	(Consumer Products)		Warrants			1,200				18,550
Camden Partners Strategic Fund II, L.P.(4)			Limited Partnership Interest			2,474				2,308
	(Private Equity Fund)
Candlewood Hotel Company(1)			Preferred Stock (3,250 shares)			3,250				748
	(Hospitality)
Celebrities, Inc.			Loan			208				208
	(Broadcasting & Cable)		Warrants			12				492
Clif Bar, Inc.			Loan			24,894				24,894
	(Consumer Products)
Colibri Holding Corporation			Loans			3,490				3,490
	(Consumer Products)		Preferred Stock (237 shares)			248				248
			Common Stock (3,362 shares)			1,250				1,088
			Warrants			290				252
Component Hardware Group, Inc.			Debt Securities			11,286				11,286
	(Industrial Products)		Preferred Stock (18,000 shares)			2,223				2,223
			Common Stock (2,000 shares)			200				500

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-9

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Cooper Natural Resources, Inc.			Loan		$	299			$	299
	(Industrial Products)		Debt Securities			1,884				1,884
			Preferred Stock (6,316 shares)			1,427				1,427
			Warrants			832				832
Coverall North America, Inc.			Loan			12,405				12,405
	(Business Services)		Debt Securities			6,424				6,424
CPM Acquisition Corporation			Loan			10,212				10,212
	(Industrial Products)
CTT Holdings			Loan			1,500				1,500
	(Consumer Products)
Drilltec Patents & Technologies			Loan			10,918				—
	Company, Inc.		Debt Securities			1,500				—
	(Industrial Products)
eCentury Capital Partners, L.P.(4)			Limited Partnership Interest			2,500				839
	(Private Equity Fund)
Elexis Beta GmbH(3)			Options			426				310
	(Industrial Products)
Eparfin S.A.(3)			Loan			29				29
	(Consumer Products)
E-Talk Corporation			Debt Securities			8,852				300
	(Business Services)		Warrants			1,157				—
Executive Greetings, Inc.			Debt Securities			18,830				16,500
	(Business Services)		Warrants			360				—
Fairchild Industrial Products			Debt Securities			5,942				5,942
	Company		Warrants			280				—
	(Industrial Products)
Frozen Specialities, Inc.			Debt Securities			9,915				9,915
	(Consumer Products)		Warrants			434				434
Galaxy American			Debt Securities			48,989				20,000
	Communications, LLC		Options			—				—
	(Broadcasting & Cable)		Standby Letter of Credit ($750)
Garden Ridge Corporation			Debt Securities			27,198				25,667
	(Retail)		Preferred Stock (1,130 shares)			1,130				—
			Common Stock (847,800 shares)			613				—
GC-Sun Holdings II, LP (Kar Products, LP)			Loans			7,780				7,780
	(Business Services)
Gibson Guitar Corporation			Debt Securities			17,952				17,952
	(Consumer Products)		Warrants			525				2,325

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-10

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Ginsey Industries, Inc.			Loans		$	5,000			$	5,000
	(Consumer Products)		Convertible Debentures			500				500
			Warrants			—				1,586
Global Communications, LLC			Loan			2,000				2,000
	(Business Services)		Debt Securities			16,247				16,247
			Preferred Equity Interest			14,067				14,067
			Options			1,639				1,639
Grant Broadcasting Systems II			Warrants			87				3,000
	(Broadcasting & Cable)
Grotech Partners, VI, L.P.(4)			Limited Partnership Interest			3,100				1,961
	(Private Equity Fund)
The Hartz Mountain Corporation			Debt Securities			27,690				27,690
	(Consumer Products)		Common Stock (200,000 shares)			2,000				2,000
			Warrants			2,613				2,613
Haven Eldercare of New England, LLC			Loan			35,692				35,692
	(Healthcare)
Headwaters Incorporated(1)			Loan			9,953				9,953
	(Industrial Products)
Hotelevision, Inc.			Preferred Stock (315,100 shares)			315				—
(Broadcasting & Cable)
Icon International, Inc.			Common Stock (35,228 shares)			1,219				2,103
(Business Services)
Impact Innovations Group, LLC			Debt Securities			6,797				3,523
	(Business Services)		Warrants			1,674				—
Intellirisk Management Corporation			Loans			23,276				23,276
	(Business Services)
Interline Brands, Inc.			Debt Securities			34,040				34,040
	(Business Services)		Preferred Stock (199,313 shares)			1,849				1,849
			Common Stock (15,615 shares)			139				139
			Warrants			1,181				1,181
Jakel, Inc.			Loan			23,307				10,130
	(Industrial Products)
JRI Industries, Inc.			Debt Securities			2,045				2,045
	(Industrial Products)		Warrants			74				44
Julius Koch USA, Inc.			Warrants			259				7,000
	(Industrial Products)
Kirker Enterprises, Inc.			Equity Interest			4				4
	(Industrial Products)		Warrants			348				3,501

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-11

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Kirkland’s, Inc.(1)			Common Stock (240,442 shares)		$	66			$	2,445
	(Retail)
Kyrus Corporation			Debt Securities			6,910				6,910
	(Business Services)		Warrants			348				450
Love Funding Corporation			Preferred Stock (26,000 shares)			359				213
	(Financial Services)
Matrics, Inc.			Preferred Stock (511,876 shares)			500				500
	(Business Services)		Warrants			—				—
MedAssets, Inc.			Debt Securities			15,880				15,880
	(Business Services)		Preferred Stock (260,417 shares)			2,049				2,049
			Warrants			136				180
Mid-Atlantic Venture Fund IV, L.P.(4)			Limited Partnership Interest			3,975				2,140
	(Private Equity Fund)
Midview Associates, L.P.			Warrants			—				—
	(Housing)
Norstan Apparel Shops, Inc.			Debt Securities			11,807				11,807
	(Retail)		Common Stock (29,622 shares)			4,750				4,750
			Warrants			655				655
North American Archery, LLC			Loans			1,390				840
	(Consumer Products)		Convertible Debentures			2,248				59
			Guaranty ($1,020)
Northeast Broadcasting Group, L.P.			Debt Securities			264				264
	(Broadcasting & Cable)
Novak Biddle Venture Partners III, L.P.(4)			Limited Partnership Interest			690				540
	(Private Equity Fund)
Nursefinders, Inc.			Debt Securities			11,205				11,205
	(Business Services)		Warrants			900				1,700
Onyx Television GmbH(3)			Preferred Units (120,000 shares)			201				—
	(Broadcasting & Cable)
Opinion Research Corporation(1)			Debt Securities			14,359				14,359
	(Business Services)		Warrants			996				641
Oriental Trading Company, Inc.			Preferred Equity Interest			1,751				1,751
	(Consumer Products)		Common Equity Interest			—				2,600
Outsource Partners, Inc.			Debt Securities			24,104				24,104
	(Business Services)		Warrants			826				1,000
Pico Products, Inc.			Loan			1,406				1,406
	(Industrial Products)

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-12

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Polaris Pool Systems, Inc.			Debt Securities		$	10,752			$	10,752
	(Consumer Products)		Warrants			1,145				1,145
Proeducation GmbH(3)			Loan			308				121
	(Education)
Raytheon Aerospace, LLC			Debt Securities			5,209				5,209
	(Business Services)		Equity Interest			—				350
Scitor Corporation			Loan			22,058				22,058
	(Business Services)
Simula, Inc.(1)			Loan			21,192				21,192
	(Industrial Products)
Soff-Cut Holdings, Inc.			Debt Securities			9,194				9,194
	(Industrial Products)		Preferred Stock (300 shares)			300				300
			Common Stock (2,000 shares)			200				200
Southwest PCS, LLC			Loan			1,250				1,250
	(Telecommunications)
Spa Lending Corporation			Preferred Stock (28,672 shares)			429				306
	(Recreation)
Startec Global Communications Corporation(1)			Loan			25,715				25,715
	(Telecommunications)		Debt Securities			20,670				—
SunStates Refrigerated Services,			Loans			4,642				1,490
	Inc.		Debt Securities			2,445				—
	(Warehouse Facilities)
Sydran Food Services II, L.P.			Debt Securities			12,973				9,949
	(Retail)		Equity Interests			3,747				—
			Warrants			162				—
Tubbs Snowshoe Company, LLC			Debt Securities			3,928				3,928
	(Consumer Products)		Equity Interests			500				500
			Warrants			54				54
United Pet Group, Inc.			Debt Securities			9,056				9,056
	(Consumer Products)		Warrants			85				235
Updata Venture Partners II, L.P.(4)			Limited Partnership Interest			1,602				4,148
	(Private Equity Fund)
Venturehouse Group, LLC(4)			Equity Interest			667				69
	(Private Equity Fund)
Walker Investment Fund II, LLLP(4)			Limited Partnership Interest			1,178				529
	(Private Equity Fund)
Warn Industries, Inc.			Debt Securities			11,531				11,531
	(Consumer Products)		Warrants			1,429				3,379

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-13

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Private Finance					December 31, 2002
Portfolio Company
(in thousands, except number of shares)			Investment(2)		Cost				Value
Wilshire Restaurant Group, Inc.			Debt Securities		$	16,180			$	16,180
	(Retail)		Warrants			735				541
Wilton Industries, Inc.			Loan			12,000				12,000
	(Consumer Products)
Woodstream Corporation			Loan			2,621				2,621
	(Consumer Products)		Debt Securities			7,677				7,677
			Equity Interests			1,700				4,547
			Warrants			450				1,203
Total companies less than 5% owned					$	863,243			$	776,951
Total private finance (123 portfolio companies)					$	1,710,902			$	1,743,215

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-14

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												December 31, 2002
				Stated
(in Thousands)				Interest				Face				Cost				Value
Commercial Real Estate Finance
Commercial Mortgage-Backed Securities
	Mortgage Capital Funding, Series 1998-MC3				5.5	%		$	50,404			$	25,162			$	22,924
	Morgan Stanley Capital I, Series 1999-RM1				6.4	%			47,566				19,491				19,627
	COMM 1999-1				5.7	%			70,159				33,771				34,720
	Morgan Stanley Capital I, Series 1999-FNV1				6.1	%			33,485				14,040				13,132
	DLJ Commercial Mortgage Trust 1999-CG2				6.1	%			74,140				31,209				31,931
	Commercial Mortgage Acceptance Corp., Series 1999-C1				6.8	%			31,884				14,316				14,954
	LB Commercial Mortgage Trust, Series 1999-C2				6.7	%			25,872				9,863				11,110
	Chase Commercial Mortgage Securities Corp., Series 1999-2				6.5	%			33,380				13,908				15,077
	FUNB CMT, Series 1999-C4				6.5	%			39,283				15,706				16,253
	Heller Financial, HFCMC Series 2000 PH-1				6.6	%			42,442				16,767				17,891
	SBMS VII, Inc., Series 2000-NL1				7.2	%			18,549				9,218				9,889
	DLJ Commercial Mortgage Trust, Series 2000-CF1				7.0	%			35,773				16,658				17,717
	Deutsche Bank Alex. Brown, Series Comm 2000-C1				6.9	%			34,935				14,803				15,901
	LB-UBS Commercial Mortgage Trust, Series 2000-C4				6.9	%			31,820				11,095				12,678
	Credit Suisse First Boston Mortgage Securities Corp., Series 2001-CK1				5.9	%			35,847				13,760				15,322
	JP Morgan-CIBC-Deutsche 2001				5.8	%			39,933				15,795				16,810
	Lehman Brothers-UBS Warburg 2001-C2				6.4	%			42,014				17,482				19,313
	SBMS VII, Inc., Series 2001-C1				6.1	%			35,536				12,579				13,377
	GE Capital Commercial Mortgage Securities Corp., Series 2001-2				6.1	%			39,012				16,195				17,350
	Credit Suisse First Boston Mortgage Securities Corp., Series 2001-CKN5				5.2	%			40,150				15,583				16,628
	JP Morgan Chase Commercial Mortgage Securities Corp., Series 2001-C1				5.6	%			37,178				12,912				13,837
	SBMS VII, Inc., Series 2001-C2				6.2	%			31,369				11,631				12,520
	FUNB CMT, Series 2002-C1				6.0	%			38,238				16,846				18,416
	GE Capital Commercial Mortgage Corp., Series 2002-1				6.2	%			80,490				44,722				52,589
	GMAC Commercial Mortgage Securities, Inc., Series 2002-C2				5.8	%			62,703				34,988				39,154
	GE Capital Commercial Mortgage Corp., Series 2002-3				5.1	%			76,687				40,309				40,817
	Morgan Stanley Dean Witter Capital I Trust 2002-IQ3				6.0	%			44,345				24,862				25,582
		Total commercial mortgage-backed securities						$	1,173,194			$	523,671			$	555,519
Collateralized Debt Obligation Preferred Shares
	Crest 2001-1, Ltd.(3)											$	23,372			$	23,372
	Crest 2002-1, Ltd.(3)												23,557				23,557
	Crest 2002-IG, Ltd.(3)												4,883				4,883
	Crest Clarendon Street 2002-1, Ltd.(3)												1,006				1,006
		Total collateralized debt obligation preferred shares										$	52,818			$	52,818

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-15

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			Interest				Number of
			Rate Ranges				Loans				Cost				Value
Commercial Mortgage Loans
				Up to 6.99%				12			$	10,190			$	11,557
				7.00%–8.99%				17				26,419				24,298
				9.00%–10.99%				7				7,764				7,764
				11.00%–12.99%				10				14,281				13,494
				13.00%–14.99%				7				7,847				6,549
			15.00% and above					1				45				45
	Total commercial mortgage loans							54			$	66,546			$	63,707
Residual Interest											$	69,335			$	69,035
Real Estate Owned												5,942				3,873
	Total commercial real estate finance										$	718,312			$	744,952
Total portfolio											$	2,429,214			$	2,488,167

(1)	Public company.
(2)	Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
(3)	Non-U.S. company.
(4)	Non-registered investment company.

F-16

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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. In April 2001, ACC established a subsidiary, A.C. Corporation (“AC Corp”), which provides diligence and structuring services on private finance and commercial real estate transactions, as well as structuring, transaction, management and advisory services to the Company, its portfolio companies and other third parties.

      ACC also owned Allied Capital SBLC Corporation (“Allied SBLC”), a BDC licensed by the Small Business Administration (“SBA”) as a Small Business Lending Company and a participant in the SBA Section 7(a) Guaranteed Loan Program. On December 31, 2000, ACC acquired BLC Financial Services, Inc. as a private portfolio company, which then changed its name to Business Loan Express, Inc. (“BLX”). As a part of the transaction, Allied SBLC was recapitalized as an independently managed, private portfolio company on December 28, 2000, and ceased to be a consolidated subsidiary of the Company at that time. Allied SBLC was then subsequently merged into BLX. The results of the operations of Allied SBLC are included in the consolidated financial results of ACC and its subsidiaries for 2000 through December 27, 2000.

      Allied Capital Corporation and its subsidiaries, collectively, are hereinafter 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 invests primarily in private companies in a variety of industries and non-investment grade commercial mortgage-backed securities (“CMBS”).

Note 2. Summary of Significant Accounting Policies

	Basis of Presentation

      The consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to the 2001 and 2000 balances to conform with the 2002 financial statement presentation.

F-17

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      During 2002, the Company revised its financial statement presentation to provide additional detail for the private finance portfolio and the interest and related portfolio income and net realized gains or losses by presenting these balances in the three categories described below. The 2001 and 2000 financial statements have been revised to conform to the 2002 presentation.

      The private finance portfolio and the interest and related portfolio income and net realized gains or losses earned 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 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 or 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.

	Valuation Of Portfolio Investments

      The Company, as a BDC, invests in illiquid securities including debt and equity securities of primarily private companies and non-investment grade CMBS. 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 company does not currently support the cost of the Company’s debt or equity investments. Conversely, 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 are determined using quoted market prices discounted for restrictions on resale.

F-18

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Loans and Debt Securities

      For loans and debt securities, fair value generally approximates cost unless the borrower’s enterprise value or 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 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 classified as Grade 4 or Grade 5 assets 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 if such companies are in need of additional capital. Loan origination fees, original issue discount and market discount are capitalized and then amortized into interest income using the effective interest method. Prepayment premiums are recorded on loans when received.

      The weighted average yield on loans and debt securities is computed as the (a) annual stated interest rate earned plus the annual amortization of loan origination fees, original issue discount and market discount earned on accruing loans and debt securities, 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’s securities or other liquidation events. The determined fair 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 upon 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.

F-19

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Commercial Mortgage-Backed Securities (“CMBS”)

      CMBS bonds are carried at fair value, which is based on a discounted cash flow model that utilizes prepayment and loss assumptions based upon historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable market yields for similar CMBS bonds. The Company’s assumption with regard to discount rate for determining fair value is based on the yield of comparable securities. 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 estimates of future credit losses, actual losses incurred, or actual and estimated prepayment speeds. 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. The Company recognizes unrealized appreciation or depreciation on its CMBS bonds as comparable yields in the market change and based on changes in estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool.

	Residual Interest

      The Company values its residual interest from a previous securitization and recognizes income using the same accounting policies used for the CMBS bonds. The residual interest is carried at fair value based on discounted estimated future cash flows. The Company recognizes income from the residual interest using the effective interest method. At each reporting date, the effective yield is recalculated and used to recognize income until the next reporting date.

	Net Realized and Unrealized Gains or Losses

      Realized gains or losses are measured by the difference between the net proceeds from the sale and the cost basis of the investment without regard to unrealized gains or losses previously recognized, and include investments charged off during the year, net of recoveries. Unrealized gains or losses reflect the change in portfolio investment values during the reporting period.

	Fee Income

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

	Deferred Financing Costs

      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.

F-20

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	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

      At December 31, 2002, 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 income, 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 income 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.

			2002				2001				2000
(in thousands, except per share amounts)
Net increase in net assets resulting from operations as reported			$	228,291			$	200,727			$	143,101
Less total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects				(6,863	)			(7,207	)			(5,385	)
Pro forma net increase in net assets resulting from operations				221,428				193,520				137,716
Less preferred stock dividends				(230	)			(230	)			(230	)
Pro forma income available to common shareholders			$	221,198			$	193,290			$	137,486
Basic earnings per common share:
	As reported		$	2.23			$	2.19			$	1.95
	Pro forma		$	2.17			$	2.11			$	1.88
Diluted earnings per common share:
	As reported		$	2.20			$	2.16			$	1.94
	Pro forma		$	2.14			$	2.08			$	1.87

      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

F-21

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Black-Scholes option pricing model, with the following weighted average assumptions for grants:

		2002				2001				2000
Risk-free interest rate			3.2	%			4.0	%			6.5	%
Expected life			5.0				5.0				5.0
Expected volatility			39.7	%			33.0	%			34.0	%
Dividend yield			8.5	%			8.0	%			8.7	%
Weighted average fair value per option		$	3.78			$	3.24			$	3.02

	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 annually distribute or retain through a deemed distribution all of their taxable income to shareholders; therefore, the Company has made no provision for income taxes for these entities. AC Corp is a corporation subject to federal and state income taxes and records a provision for income taxes as appropriate.

	Per Share Information

      Basic earnings per share is calculated using the weighted average number of shares outstanding for the period presented. Diluted earnings per 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 accounting principles generally accepted in the United States of America 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 $2,488,167,000 and $2,329,590,000 as of December 31, 2002 and 2001, respectively (89% and 95%, respectively, of total assets). Substantially all of these investments represent 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.

F-22

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	New Accounting Pronouncements

      In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (the Interpretation) which expands on the accounting guidance of Statements No. 5, 57 and 107 and incorporates without change the provisions of FASB Interpretation No. 34, which is being superceded. The Interpretation will significantly change current practice in the accounting for and disclosure of guarantees. Guarantees meeting the characteristics described in the Interpretation are to be recognized at fair value and significant disclosure rules have been implemented even if the likelihood of the guarantor making payments is remote. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002, while the initial measurement provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. Certain guarantees are excluded from the initial recognition provisions of the Interpretation, however specific disclosures are still required. The Company does not expect that the initial recognition provisions will have a significant effect on the Company’s financial position or its results of operations. See Note 5 for the disclosures related to the Company’s guarantees.

      In December 2002, the FASB issued Statement No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123. This Statement amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Company has not yet determined if it will adopt the provisions to expense the costs related to stock-based employee compensation. In addition, this statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements of the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The disclosure requirements are effective for these financial statements and have been included above.

Note 3. Portfolio

	Private Finance

      At December 31, 2002 and 2001, the private finance portfolio consisted of the following:

		2002												2001
		Cost				Value				Yield				Cost				Value				Yield
($ in thousands)
Loans and debt securities		$	1,272,401			$	1,151,256				14.4	%		$	1,169,673			$	1,107,890				14.8	%
Equity interests			438,501				591,959								384,293				487,182
Total		$	1,710,902			$	1,743,215							$	1,553,966			$	1,595,072

      Private finance investment activity principally involves providing financing through privately negotiated long-term debt and equity investments. Private finance investments are

F-23

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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. Private finance investments are generally issued by privately-owned companies and are generally illiquid and subject to restrictions on resale or transferability.

      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. At December 31, 2002 and 2001, approximately 95% and 98%, respectively, of the Company’s loans and debt securities had fixed interest rates.

      Equity interests consist primarily of securities issued by privately owned companies and may be subject to restrictions on their resale or may be otherwise illiquid. Equity securities generally do not produce a current return, but are held in anticipation of investment appreciation and ultimate gain on sale.

      The Company may acquire more than 50% of the common stock of a portfolio company in a control buyout transaction. The Company’s most significant investments acquired through control buyout transactions at December 31, 2002 and 2001, were Business Loan Express, Inc., The Hillman Companies, Inc., and WyoTech Acquisition Corporation.

      At December 31, 2002 and 2001, the Company had an investment at value totaling $256,801,000 and $227,449,000, respectively, in Business Loan Express, Inc. (“BLX”), a small business lender that participates in the U.S. Small Business Administration 7(a) Guaranteed Loan Program. At December 31, 2002, the Company owned 94.9% of BLX’s common stock. The Company’s common stock ownership is subject to dilution by management options. As the controlling shareholder of BLX, the Company has provided an unconditional guaranty to the BLX credit facility lenders in an amount up to 50% of the total obligations (consisting of principal, accrued interest and other fees) on BLX’s three-year unsecured $124,000,000 revolving credit facility that matures in March 2004. The amount guaranteed by the Company at December 31, 2002, was $51,641,000. 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, 2002. In consideration for providing this guaranty, BLX paid the Company a guaranty fee of $3,100,000 and $2,285,000 in 2002 and 2001, respectively. The Company has also provided two standby letters of credit in connection with two term securitization transactions completed by BLX totaling $10,550,000. BLX is headquartered in New York, NY.

      At December 31, 2002 and 2001, the Company had an investment in The Hillman Companies, Inc. totaling $180,468,000 and $97,227,000 at value, respectively. At December 31, 2002, the Company owned 96.8% of Hillman’s common stock. The Company’s common stock ownership is subject to dilution by management options. Hillman is a leading manufacturer of key making equipment and distributor of key blanks, fasteners, signage, and other small hardware components and operates in multiple channels of the retail marketplace such as hardware stores, national and regional home centers, and

F-24

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

mass merchants. Hillman has certain patent-protected products, including key duplication technology, that is important to its business. Hillman’s primary operations are located in Cincinnati, Ohio.

      At December 31, 2001, the Company had an investment in WyoTech Acquisition Corporation at value totaling $60,388,000. WyoTech is a proprietary trade school and its primary operations are in Laramie, Wyoming. On July 1, 2002, the Company completed the sale of WyoTech Acquisition Corporation to a third party. The Company’s total proceeds from the sale of WyoTech, including the repayment of debt and preferred stock and the sale of the Company’s 91% common equity ownership, were $77,230,000, resulting in a realized gain of $60,755,000 in the third quarter of 2002. The sale of WyoTech is subject to post-closing working capital adjustments, if any, and customary indemnification provisions.

      Total interest and portfolio related income earned from the Company’s investments in BLX, Hillman, and WyoTech for the year ended December 31, 2002, was $53,137,000.

      At December 31, 2002 and 2001, loans and debt securities in workout status (classified as Grades 4 and 5 under the Company’s internal grading system) that were not accruing interest were as follows at value:

			2002				2001
(in thousands)
Companies more than 25% owned			$	9,709			$	153
Companies 5% to 25% owned				411				3,418
Companies less than 5% owned				65,931				77,354
	Total		$	76,051			$	80,925

      Included in Grade 4 and 5 loans and debt securities not accruing interest were assets valued at $8,905,000 at December 31, 2001, that were related to portfolio companies in liquidation. As of December 31, 2002, $7,646,000 at value representing receivables related to portfolio companies in liquidation were included in other assets.

      In addition to Grade 4 and 5 assets that are in workout, the Company may not accrue interest on loans and debt securities to companies that are more than 50% owned by the Company if such companies are in need of additional capital and, therefore, the Company may defer current debt service. Loans and debt securities to such companies totaled $63,577,000 at value at December 31, 2002. Loans to companies which are less than 50% owned by the Company that were not in workout, but were not accruing interest totaled $7,166,000 and $12,819,000 at value at December 31, 2002 and 2001, respectively.

F-25

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The industry and geographic compositions of the private finance portfolio at value at December 31, 2002 and 2001, were as follows:

			2002				2001
Industry
Consumer products				34	%			28	%
Business services				26				22
Financial services				16				15
Industrial products				9				10
Healthcare services				5				3
Retail				4				5
Telecommunications				2				4
Broadcasting & cable				1				4
Education				1				5
Other				2				4
	Total			100	%			100	%
Geographic Region
Mid-Atlantic				45	%			43	%
Midwest				16				17
Southeast				16				14
West				15				19
Northeast				7				5
International				1				2
	Total			100	%			100	%

	Commercial Real Estate Finance

      At December 31, 2002 and 2001, the commercial real estate finance portfolio consisted of the following:

			2002												2001
			Cost				Value				Yield				Cost				Value				Yield
($ in thousands)
CMBS bonds			$	523,671			$	555,519				14.2	%		$	558,346			$	558,346				14.7	%
Collateralized debt obligation preferred shares				52,818				52,818				17.2	%			24,207				24,207				16.9	%
Loans				66,546				63,707				7.5	%			76,120				79,597				7.7	%
Residual interest				69,335				69,035				9.4	%			70,179				69,879				9.4	%
Real estate owned				5,942				3,873								3,784				2,489
	Total		$	718,312			$	744,952							$	732,636			$	734,518

F-26

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      CMBS Bonds. At December 31, 2002 and 2001, CMBS bonds consisted of the following:

		2002				2001
($ in thousands)
Face		$	1,173,194			$	1,170,272
Original issue discount			(649,523	)			(611,926	)
Cost		$	523,671			$	558,346
Value		$	555,519			$	558,346

      The non-investment grade and unrated tranches of 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 generally is allocated first to the senior tranches, 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, 2002, the Company’s CMBS bonds were subordinate to 91% to 97% of the tranches of bonds issued in various CMBS transactions. Given that the non-investment grade CMBS bonds in which the Company invests are junior in priority for payment of principal, the Company invests in these CMBS bonds at a significant discount from the face amount of the bonds.

      The underlying rating classes of the CMBS bonds at value at December 31, 2002, and 2001 were as follows:

			2002								2001
							Percentage								Percentage
			Value				of Total				Value				of Total
($ in thousands)
BB+			$	49,811				9.0	%		$	24,785				4.4	%
BB				39,011				7.0				69,404				12.4
BB-				22,030				4.0				67,460				12.1
B+				121,038				21.8				103,560				18.6
B				141,998				25.6				131,362				23.5
B-				83,493				15.0				73,572				13.2
CCC				8,634				1.5				8,893				1.6
Unrated				89,504				16.1				79,310				14.2
	Total		$	555,519				100.0	%		$	558,346				100.0	%

      At December 31, 2002 and 2001, the underlying pools of mortgage loans that are collateral for the Company’s CMBS bonds consisted of approximately 4,500 and 3,800 commercial mortgage loans with a total outstanding principal balance of $24,974,035,000 and $20,548,643,000, respectively. At December 31, 2002 and 2001, 1.0% and 0.5%, respectively, of the mortgage loans in the underlying collateral pool for the Company’s CMBS bonds were over 30 days delinquent or were classified as real estate owned. The property types and the geographic composition of the underlying mortgage loans in the

F-27

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

underlying collateral pool calculated using the outstanding principal balance at December 31, 2002 and 2001, were as follows:

			2002				2001
Property Type
Retail				32	%			31	%
Housing				27				27
Office				21				22
Industrial Real Estate				7				6
Hospitality				6				7
Other				7				7
	Total			100	%			100	%
Geographic Region
West				31	%			32	%
Mid-Atlantic				25				24
Midwest				22				21
Southeast				17				17
Northeast				5				6
	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 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 competition for tenants and their related credit quality) and changes in market rental rates. The initial yield on each CMBS bond has been computed assuming an approximate 1% loss rate on its entire 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 amount of losses and the expected timing of recognition of such losses will be updated, and the respective yield will be adjusted as necessary. As of December 31, 2002, the Company has identified specific losses of $27,980,000, which will reduce the face amount and original issue discount on the CMBS bonds, but will not result in a change in the cost and value of the CMBS bonds. 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.

      The Company acts as the directing certificate holder for the CMBS bonds, which allows the Company to approve disposition plans for individual loans in the underlying collateral pool.

      Collateralized Debt Obligation Preferred Shares. At December 31, 2002, the Company owned preferred shares in four collateralized debt obligations (“CDOs”) totaling $52,818,000 at value secured by investment grade unsecured debt issued by various real estate investment trusts (“REITs”) and investment and non-investment grade CMBS bonds. The investment grade REIT collateral consists of debt with a cut-off balance of $1,017,553,000 and was issued by 42 REITs. The investment grade CMBS collateral

F-28

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

consists of CMBS bonds with a face amount of $479,021,000 issued in 39 separate CMBS transactions. The non-investment grade CMBS collateral consists of BB+, BB, and BB– CMBS bonds with a face amount of $463,426,000 issued in 39 separate CMBS transactions (“CMBS Collateral”). Included in the CMBS Collateral for the CDOs are $397,872,000 of CMBS bonds that are senior in priority of repayment to certain lower rated CMBS bonds held by the Company, which were issued in 23 separate CMBS transactions. The preferred shares are junior in priority for payment of principal and interest to the more senior tranches of debt issued by the CDOs. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, the preferred shares will bear this loss first. At December 31, 2002, the Company’s preferred shares in the CDOs were subordinate to approximately 96% of the more senior tranches of debt issued by the CDOs.

      The Company acts as the disposition consultant with respect to three of the CDOs, which allows the Company to approve disposition plans for individual collateral securities. For these services with respect to the CDOs, the Company collects annual fees based on the outstanding collateral pool balance, and for the years ended December 31, 2002 and 2001, this fee totaled $526,000 and $108,000, respectively.

      Loans. The commercial mortgage loan portfolio contains loans that were originated by the Company or were purchased from third-party sellers. At December 31, 2002 and 2001, approximately 84% and 16% and 76% and 24% of the Company’s commercial mortgage loan portfolio was composed of fixed and adjustable interest rate loans, respectively. As of December 31, 2002 and 2001, loans with a value of $13,016,000 and $15,241,000, respectively, were not accruing interest.

      The property types and the geographic composition securing the commercial mortgage loan portfolio at value at December 31, 2002 and 2001, were as follows:

			2002				2001
Property Type
Hospitality				23	%			25	%
Retail				21				21
Office				20				34
Healthcare				15				—
Recreation				3				4
Other				18				16
	Total			100	%			100	%

F-29

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

			2002				2001
Geographic Region
Southeast				40	%			36	%
West				20				20
Mid-Atlantic				17				23
Midwest				12				16
Northeast				11				5
	Total			100	%			100	%

      Residual Interest. At December 31, 2002 and 2001, the residual interest consisted of the following:

			2002								2001
			Cost				Value				Cost				Value
(in thousands)
Residual interest			$	68,853			$	68,853			$	68,853			$	68,853
Residual interest spread				482				182				1,326				1,026
	Total		$	69,335			$	69,035			$	70,179			$	69,879

      The residual interest primarily consists of a retained interest totaling $68,853,000 from a 1998 asset securitization whereby bonds were sold in three classes rated AAA, AA and A. The residual interest represents a right to cash flows from the underlying collateral pool of loans after these senior bond obligations are satisfied. At December 31, 2002, one class of bonds rated AAA was outstanding, totaling $17,640,000. The Company has the right to call the bonds upon a minimum of ten days notice to the bondholders. Once the bonds are fully repaid, either through the cash flows from the securitized loans or due to the Company calling the bonds, the remaining loans in the trust will be returned to the Company as payment on the residual interest.

      The Company sold $295 million of loans, and received cash proceeds, net of costs, of approximately $223 million in January 1998. The Company retained a trust certificate for its residual interest in a loan pool sold, and will receive interest income from this residual interest as well as the residual interest spread (“Residual”) from the interest earned on the loans sold less the interest paid on the bonds over the life of the bonds. As of December 31, 2002 and 2001, the mortgage loan pool had an approximate weighted average stated interest rate of 8.8% and 9.3% respectively. The outstanding bond classes sold had an aggregate weighted average interest rate of 6.7% and 6.6% as of December 31, 2002 and 2001, respectively.

      The Company uses a discounted cash flow methodology for determining the fair value of its retained Residual. In determining the cash flow of the Residual, the Company assumes a prepayment speed of 15% after the applicable prepayment lockout period and credit losses of 1% or approximately $813,000 of the total principal balance of the underlying collateral throughout the life of the collateral. These assumptions result in an expected weighted average life of the bonds of four months. The value of the resulting Residual cash flows is then determined by applying a discount rate of 9% which, in the Company’s view, is commensurate with the market risk of comparable assets.

F-30

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Tax Basis. At December 31, 2002, the aggregate gross unrealized appreciation of the Company’s investments over cost for federal income tax purposes was $302,965,000. At December 31, 2002, the aggregate gross unrealized depreciation of the Company’s investments under cost for federal income tax purposes was $196,181,000. At December 31, 2002, the aggregate cost of securities, for federal income tax purposes was $2,381,383,000.

Note 4. Debt

      At December 31, 2002 and 2001, the Company had the following debt:

				2002								2001
				Facility				Amount				Facility				Amount
				Amount				Drawn				Amount				Drawn
(in thousands)
Notes payable and debentures:
	Unsecured long-term notes payable			$	694,000			$	694,000			$	694,000			$	694,000
	SBA debentures				101,800				94,500				101,800				94,500
	Auction rate reset note				—				—				81,856				81,856
	OPIC loan				5,700				5,700				5,700				5,700
		Total notes payable and debentures			801,500				794,200				883,356				876,056
Revolving line of credit					527,500				204,250				497,500				144,750
	Total			$	1,329,000			$	998,450			$	1,380,856			$	1,020,806

	Notes Payable and Debentures

      Unsecured Long-Term Notes Payable. The Company 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, 2002, the notes had remaining maturities of five months to four years. The weighted average fixed interest rate on the notes was 7.6% at December 31, 2002 and 2001. The notes may be prepaid in whole or in part, together with an interest premium, as stipulated in the note agreement.

      SBA Debentures. At December 31, 2002 and 2001, the Company had debentures payable to the SBA with original terms of ten years and at fixed interest rates ranging from 5.9% to 8.2% and 2.4% to 8.2%, respectively. At December 31, 2002, the debentures had remaining maturities of two to nine years. The weighted average interest rate was 7.0% and 6.7% at December 31, 2002 and 2001, respectively. 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, 2002, the Company has a commitment from the SBA to borrow up to an additional $7,300,000 above the amount outstanding. The commitment expires on September 30, 2005.

F-31

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Auction Rate Reset Note. At December 31, 2001, the Company had an Auction Rate Reset Senior Note Series A that bore interest at the three-month London Interbank Offered Rate (“LIBOR”) plus 1.75%, which adjusted quarterly. Interest was due quarterly and the note matured on December 27, 2002. The Company repaid the note in full at maturity.

      The Company has entered into an agreement with the placement agent of this note to serve as the placement agent on a future issuance of $75,000,000 of debt, equity, or other securities in one or more public or private transactions. If the Company does not conduct a capital raise, the Company will incur additional expenses of approximately $3,188,000.

      Scheduled future maturities of notes payable and debentures at December 31, 2002, are as follows:

			Amount Maturing
Year			(in thousands)
2003			$	140,000
2004				221,000
2005				179,000
2006				180,700
2007				—
Thereafter				73,500
	Total		$	794,200

	Revolving Line of Credit

      The Company has an unsecured revolving line of credit for $527,500,000 at December 31, 2002. The facility may be expanded up to $600,000,000 at the Company’s option. The facility bears interest at a rate equal to (i) the one-month LIBOR plus 1.25%, (ii) the Bank of America, N.A. prime rate, or (iii) the Federal Funds rate plus 0.50% at the Company’s option. The interest rate adjusts at the beginning of each new interest period, usually every 30 days. The interest rates were 2.7% and 3.2% at December 31, 2002 and 2001, respectively, and the facility requires an annual commitment fee equal to 0.25% of the committed amount. The line expires in August 2003 and may be extended under substantially similar terms for one additional year at the Company’s sole option. The line of credit requires monthly interest payments and all principal is due upon its expiration.

      The average debt outstanding on the revolving line of credit was $68,266,000 and $106,338,000 for the years ended December 31, 2002 and 2001, respectively. The maximum amount borrowed under this facility and the weighted average interest rate for the years ended December 31, 2002 and 2001, were $216,500,000 and $213,500,000, and 3.2% and 5.4%, respectively. As of December 31, 2002, the amount available under the revolving line of credit was $317,950,000, net of amounts committed for standby letters of credit of $5,300,000 issued under the credit facility.

      The Company records debt at cost. The fair value of the Company’s total debt was $1,050,452,000 at December 31, 2002.

F-32

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The Company has various financial and operating covenants required by the revolving line of credit and the notes payable and debentures. 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, 2002, the Company was in compliance with these covenants.

Note 5. Guarantees

      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. As of December 31, 2002, the Company has issued guarantees of debt, rental obligations, and lease obligations aggregating $54,628,000 and has extended standby letters of credit aggregating $11,300,000. 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 future payments is $65,928,000. At December 31, 2002, no amounts have been recorded as a liability for the Company’s guarantees or standby letters of credit.

      As of December 31, 2002, the commitments expire as follows:

		Total				2003				2004				2005				2006				2007				After 2007
(in thousands)
Guarantees of debt and lease obligations		$	54,628			$	1,718			$	52,349			$	311			$	139			$	111			$	—
Standby letters of credit			11,300				—				5,300				—				—				—				6,000
Total		$	65,928			$	1,718			$	57,649			$	311			$	139			$	111			$	6,000

Note 6. Preferred Stock

      Allied Investment has 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. The 3% cumulative preferred stock does not have a required redemption date. Allied Investment has the option to redeem in whole or in part the preferred stock by paying the SBA the par value of such securities and any dividends accumulated and unpaid to the date of redemption. The 4% redeemable cumulative preferred stock has a required redemption date in June 2005.

F-33

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 7. Shareholders’ Equity

      Sales of common stock for the years ended December 31, 2002 and 2001, were as follows:

			2002				2001				2000
(in thousands)
Number of common shares				8,047				13,286				14,812
Gross proceeds			$	177,345			$	301,539			$	263,460
Less costs including underwriting fees				(4,498	)			(14,651	)			(12,548	)
	Net proceeds		$	172,847			$	286,888			$	250,912

      In addition, the Company issued 204,855 shares of common stock with a value of $5,157,000 to acquire one portfolio investment in a stock-for-stock exchange during 2001. The Company also issued 4,123,407 shares of common stock with a value of $86,076,000 to acquire BLC Financial Services, Inc. in a stock-for-stock exchange on December 31, 2000.

      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 days immediately prior to the dividend payment date.

      Dividend reinvestment plan activity for the years ended December 31, 2002, 2001, and 2000, was as follows:

		2002				2001				2000
(in thousands, except per share amounts)
Shares issued			275				271				254
Average price per share		$	22.78			$	23.32			$	18.79

F-34

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 8. Earnings Per Common Share

      Earnings per common share for the years ended December 31, 2002, 2001, and 2000, were as follows:

		2002				2001				2000
(in thousands, except per share amounts)
Net increase in net assets resulting from operations		$	228,291			$	200,727			$	143,101
Less preferred stock dividends			(230	)			(230	)			(230	)
Income available to common shareholders		$	228,061			$	200,497			$	142,871
Basic shares outstanding			102,107				91,564				73,165
Dilutive options outstanding to officers			1,467				1,439				307
Diluted shares outstanding			103,574				93,003				73,472
Basic earnings per common share		$	2.23			$	2.19			$	1.95
Diluted earnings per common share		$	2.20			$	2.16			$	1.94

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

      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 $11,000 annually for the 2002 plan year. Plan participants who reached the age of 50 during the 2002 plan year were eligible to defer an additional $1,000 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, 2002, the maximum compensation was $200,000. 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, 2002, 2001, and 2000 was $599,000, $560,000, and $590,000, 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 to the extent 401(k) contributions for eligible participants exceed the amount permitted by the Internal Revenue Service. Contribution expense for the deferred compensation plan for the years ended December 31, 2002, 2001, and 2000, was $296,000, $272,000, and $197,000, 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

F-35

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the Company’s insolvency. Amounts deferred by participants under the deferred compensation plan are funded to a trust, which is administered by Company-appointed trustees.

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. On May 7, 2002, the Company’s shareholders amended the Option Plan to increase the authorized shares under the plan to 25,950,000. At December 31, 2002, the number of shares available to be granted under the Option Plan was 9,415,000.

      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 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.

F-36

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Information with respect to options granted, exercised and forfeited under the Option Plan for the years ended December 31, 2002, 2001, and 2000, is as follows:

						Weighted
						Average
						Exercise Price
		Shares				Per Share
(in thousands, except per share amounts)
Options outstanding at January 1, 2000			5,889			$	20.12
Granted			4,162				17.02
Exercised			(195	)			17.68
Forfeited			(950	)			19.81
Options outstanding at December 31, 2000			8,906			$	18.76
Granted			2,800				21.82
Exercised			(553	)			19.09
Forfeited			(673	)			17.66
Options outstanding at December 31, 2001			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

      The following table summarizes information about stock options outstanding at December 31, 2002:

		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–$17.75			3,212				7.35			$	16.94				2,128			$	16.94
$17.88–$21.38			3,008				5.45			$	20.71				2,374			$	20.82
$21.52			5,462				9.95			$	21.52				—			$	21.52
$21.59–$26.29			2,907				8.66			$	22.44				1,029			$	22.10
$27.38			100				9.09			$	27.38				—			$	27.38
$16.81–$27.38			14,689				8.20			$	20.57				5,531			$	19.56

F-37

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      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

      The Company provided loans to officers for the exercise of options. The 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, 2002 and 2001, the Company had outstanding loans to officers of $24,704,000 and $26,028,000, respectively. Officers with outstanding loans repaid principal of $3,706,000, $5,090,000, and $6,363,000, for the years ended December 31, 2002, 2001, and 2000, respectively. The Company recognized interest income from these loans of $1,507,000, $1,524,000, and $1,712,000, respectively, during these same periods. This interest income is included in interest and dividends for companies less than 5% owned.

      As a business development company under the Investment Company Act of 1940, the Company is entitled to provide loans to the Company’s employees 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.

Note 11. Dividends and Distributions

      For the years ended December 31, 2002, 2001, and 2000, the Company declared the following distributions:

		2002								2001								2000
		Total				Total Per				Total				Total Per				Total				Total Per
		Amount				Share				Amount				Share				Amount				Share
(in thousands, except per share amounts)
First quarter		$	53,259			$	0.53			$	42,080			$	0.49			$	30,715			$	0.45
Second quarter			56,224				0.55				45,755				0.50				33,150				0.45
Third quarter			57,340				0.56				47,866				0.51				34,751				0.46
Fourth quarter			59,851				0.56				50,456				0.51				37,179				0.46
Extra dividend			3,261				0.03				—				—				—				—
Total distributions to common shareholders		$	229,935			$	2.23			$	186,157			$	2.01			$	135,795			$	1.82

F-38

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      For income tax purposes, distributions for 2002, 2001, and 2000, were composed of the following:

		2002								2001								2000
		Total				Total Per				Total				Total Per				Total				Total Per
		Amount				Share				Amount				Share				Amount				Share
(in thousands, except per share amounts)
Ordinary income(1)		$	178,246			$	1.73			$	183,957			$	1.99			$	116,321			$	1.56
Long-term capital gains			51,689				0.50				2,200				0.02				19,474				0.26
Total distributions to common shareholders		$	229,935			$	2.23			$	186,157			$	2.01			$	135,795			$	1.82

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(1)	For certain eligible corporate shareholders, the dividend received deduction for 2002 was $0.08 per share.

     The following table summarizes the differences between financial statement net increase in net assets resulting from operations and taxable income for the years ended December 31, 2002, 2001, and 2000:

			2002				2001				2000
(in thousands)
Financial statement net increase in net assets resulting from operations			$	228,291			$	200,727			$	143,101
Adjustments:
	Net unrealized losses (gains)			571				(20,603	)			(14,861	)
	Interest income from securitized commercial mortgage loans			1,258				3,327				3,149
	Amortization of discounts and fees			(8,541	)			8,043				2,771
	Gains from disposition of portfolio assets			—				—				5,202
	Formula award			—				(4,383	)			1,374
	Other expenses not deductible for tax			1,815				3,230				1,197
	Other			5,708				(2,368	)			(3,550	)
	Income tax expense (benefit)			930				(412	)			—
Taxable income			$	230,032			$	187,561			$	138,383

      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. For the years ended December 31, 2002 and 2001, the Company recorded tax expense of $930,000 and a tax benefit of $412,000, respectively.

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.

F-39

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      At December 31, 2002 and 2001, cash and cash equivalents consisted of the following:

			2002				2001
(in thousands)
Cash and cash equivalents			$	15,497			$	5,337
Less escrows held				(4,311	)			(4,448	)
	Total cash and cash equivalents		$	11,186			$	889

Note 13. Supplemental Disclosure of Cash Flow Information

      For the years ended December 31, 2002, 2001, and 2000, the Company paid $69,143,000, $63,237,000, and $54,112,000, respectively, for interest. For years ended December 31, 2002, 2001, and 2000, the Company’s non-cash financing activities totaled $8,644,000, $17,523,000, and $92,835,000, respectively, and includes stock option exercises and dividend reinvestment. The non-cash financing activities for the years ended December 31, 2001 and 2000, also include the issuance of $5,157,000 and $86,076,000 of the Company’s common stock to acquire portfolio investments.

Note 14. Hedging Activities

      The Company invests in CMBS 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 BB+ through B rated CMBS bonds. These transactions involved the Company receiving the proceeds from the sale 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, including accrued interest payable on the obligations, as of December 31, 2002 and 2001, consisted of the following:

(in thousands)			2002				2001
Description of Issue			Value				Value
10-year Treasury, due August 2011			$	—			$	17,989
10-year Treasury, due August 2011				—				5,656
10-year Treasury, due August 2011				—				23,618
10-year Treasury, due February 2012				2,880				—
10-year Treasury, due February 2012				28,573				—
10-year Treasury, due February 2012				20,600				—
10-year Treasury, due November 2012				23,415				—
10-year Treasury, due November 2012				19,494				—
5-year Treasury, due November 2007				37,647				—
10-year Treasury, due November 2012				64,418				—
	Total		$	197,027			$	47,263

      As of December 31, 2002, the total obligations on the hedge had increased since the original sale date due to changes in the yield on the borrowed Treasury securities, resulting

F-40

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

in unrealized depreciation on the obligations of $7,062,000. The net proceeds related to the sales of the borrowed Treasury securities were $189,340,000 and $48,504,000 at December 31, 2002 and 2001, respectively. Under the terms of the transactions, the Company has provided additional cash collateral of $5,405,000 at December 31, 2002, 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 the financial institutions under repurchase agreements. The repurchase agreements are collateralized by U.S. Treasury securities and are settled weekly. As of December 31, 2002, the repurchase agreements were due on January 3, 2003, and had a weighted average interest rate of 0.8%. This Note has been revised to further disclose the detail of the borrowed Treasury securities as of December 31, 2001.

Note 15. Financial Highlights

			At and for the Years
			Ended December 31,
			2002				2001
Per Common Share Data
Net asset value, beginning of year			$	13.57			$	12.11
	Net investment income before net realized and unrealized gains(1)			1.77				1.93
	Net realized and unrealized gains(1)			0.43				0.23
Net increase in net assets resulting from operations				2.20				2.16
Net decrease in net assets from shareholder distributions				(2.23	)			(2.01	)
Net increase in net assets from capital share transactions				0.68				1.31
Net asset value, end of year			$	14.22			$	13.57
Market value, end of year			$	21.83			$	26.00
Total return				(7	)%			36	%

F-41

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

		At and for the Years
		Ended December 31,
		2002				2001
Ratios and Supplemental Data ($ and shares in thousands, except per share amounts)
Ending net assets		$	1,546,071			$	1,352,123
Common shares outstanding at end of year			108,698				99,607
Diluted weighted average common shares outstanding			103,574				93,003
Employee and administrative expenses/average net assets			3.82	%			3.80	%
Total expenses/average net assets			8.75	%			9.31	%
Net investment income before net realized and unrealized gains/average net assets			12.94	%			15.15	%
Net increase in net assets resulting from operations/average net assets			15.98	%			16.99	%
Portfolio turnover rate			15.12	%			10.04	%
Average debt outstanding		$	938,148			$	847,121
Average debt per share		$	9.06			$	9.11

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(1)	Based on diluted weighted average number of shares outstanding for the period.

Note 16. Selected Quarterly Data (Unaudited)

		2002
(in thousands, except per share amounts)		Qtr. 1				Qtr. 2				Qtr. 3				Qtr. 4
Total interest and related portfolio income		$	82,391			$	73,193			$	76,329			$	78,015
Net investment income before net realized and unrealized gains		$	53,869			$	42,561			$	45,094			$	42,401
Net increase in net assets resulting from operations		$	55,961			$	73,454			$	45,520			$	53,356
Basic earnings per common share		$	0.56			$	0.72			$	0.44			$	0.51
Diluted earnings per common share		$	0.55			$	0.71			$	0.44			$	0.51

		2001
		Qtr. 1				Qtr. 2				Qtr. 3				Qtr. 4
Total interest and related portfolio income		$	65,071			$	68,739			$	72,634			$	82,666
Net investment income before net realized and unrealized gains		$	39,728			$	42,118			$	44,189			$	53,428
Net increase in net assets resulting from operations		$	52,028			$	46,106			$	59,703			$	42,890
Basic earnings per common share		$	0.61			$	0.52			$	0.64			$	0.44
Diluted earnings per common share		$	0.60			$	0.51			$	0.63			$	0.43

Note 17. Litigation

      A series of class action lawsuits were filed in 2002 in the United States District Court for the Southern District of New York against the Company, certain of its directors and officers and its former independent auditors, Arthur Andersen LLP, with respect to alleged

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

violations of the securities laws. Specifically, these lawsuits allege that the defendants violated Section 10(b), Rule 10b-5, and Section 20(a) of the Securities Exchange Act of 1934 by purportedly misstating the value of certain portfolio investments in the Company’s financial statements, which allegedly resulted in the purchase of the Company’s common stock by purported class members at artificially inflated prices. Several of the complaints also alleged state law claims for common law fraud. The complaints seek compensatory and other damages, and costs and expenses associated with the litigation. The lawsuits have been consolidated into a single proceeding. The consolidated complaint does not include Arthur Andersen LLP as a named defendant or assert any state law claims against the remaining named defendants. The Company has filed a motion to dismiss the lawsuit and the plaintiffs have filed an opposition to this motion. The Company has filed a reply to the plaintiff’s opposition. The Company believes that the lawsuit is without merit, and it intends to defend the lawsuit vigorously. While the Company does not expect these matters to materially affect its financial condition or results of operations, there can be no assurance as to whether any such pending litigation will have a material adverse effect on its financial condition or results of operations in any future reporting period.

      The Company also is party to certain other 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.

F-43

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATING BALANCE SHEET

				December 31, 2002
				Allied				Allied												Consolidated
				Capital				Investment				Others				Eliminations				Total
(in thousands)
ASSETS
Portfolio at value:
	Private finance			$	1,586,886			$	140,807			$	15,522			$	—			$	1,743,215
	Commercial real estate finance				660,653				3,485				80,814				—				744,952
	Investments in subsidiaries				130,353				—				—				(130,353	)			—
		Total portfolio at value			2,377,892				144,292				96,336				(130,353	)			2,488,167
Deposits of proceeds from sales of borrowed Treasury securities					194,745				—				—				—				194,745
Other assets					62,255				9,368				28,598				—				100,221
Intercompany notes and receivables					69,435				132				16,935				(86,502	)			—
Cash and cash equivalents					1,722				8,926				538				—				11,186
		Total assets		$	2,706,049			$	162,718			$	142,407			$	(216,855	)		$	2,794,319
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
	Notes payable and debentures			$	699,700			$	94,500			$	—			$	—			$	794,200
	Revolving line of credit				204,250				—				—				—				204,250
	Obligations to replenish borrowed Treasury securities				197,027				—				—				—				197,027
	Accounts payable and other liabilities				29,590				2,259				13,922				—				45,771
	Intercompany notes and payables				29,411				29				57,062				(86,502	)			—
		Total liabilities			1,159,978				96,788				70,984				(86,502	)			1,241,248
Commitments and contingencies
Preferred stock					—				7,000				—				—				7,000
Shareholders’ equity:
	Common stock				11				—				1				(1	)			11
	Additional paid-in capital				1,547,183				53,923				79,116				(133,039	)			1,547,183
	Notes receivable from sale of common stock				(24,704	)			—				—				—				(24,704	)
	Net unrealized appreciation (depreciation) on portfolio				39,411				(11,849	)			(4,202	)			16,051				39,411
	Undistributed (distributions in excess of) earnings				(15,830	)			16,856				(3,492	)			(13,364	)			(15,830	)
		Total shareholders’ equity			1,546,071				58,930				71,423				(130,353	)			1,546,071
		Total liabilities and shareholders’ equity		$	2,706,049			$	162,718			$	142,407			$	(216,855	)		$	2,794,319

F-44

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATING STATEMENT OF OPERATIONS

				For the Year Ended December 31, 2002
				Allied				Allied												Consolidated
				Capital				Investment				Others				Eliminations				Total
(in thousands)
Interest and Related Portfolio Income
	Interest and dividends			$	240,771			$	16,158			$	7,113			$	—			$	264,042
	Intercompany interest				4,612				—				—				(4,612	)			—
	Premiums from loan dispositions				2,654				122				—				—				2,776
	Income from investments in wholly owned subsidiaries				5,525				—				—				(5,525	)			—
	Fees and other income				15,158				227				38,583				(10,858	)			43,110
		Total interest and related portfolio income			268,720				16,507				45,696				(20,995	)			309,928
Expenses
	Interest				62,991				7,452				—				—				70,443
	Intercompany interest				—				4				4,608				(4,612	)			—
	Employee				12,373				—				20,753				—				33,126
	Administrative				17,632				113				14,617				(10,858	)			21,504
		Total operating expenses			92,996				7,569				39,978				(15,470	)			125,073
Net investment income before income taxes and net realized and unrealized gains					175,724				8,938				5,718				(5,525	)			184,855
Income tax expense					—				—				930				—				930
Net investment income before net realized and unrealized gains					175,724				8,938				4,788				(5,525	)			183,925
Net Realized and Unrealized Gains (Losses)
	Net realized gains (losses)				53,138				(4,429	)			(3,772	)			—				44,937
	Net unrealized losses				(571	)			(21,875	)			(2,401	)			24,276				(571	)
		Total net realized and unrealized gains (losses)			52,567				(26,304	)			(6,173	)			24,276				44,366
Net increase (decrease) in net assets resulting from operations				$	228,291			$	(17,366	)		$	(1,385	)		$	18,751			$	228,291

F-45

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATING STATEMENT OF CASH FLOWS

					For the Year Ended December 31, 2002
					Allied				Allied												Consolidated
					Capital				Investment				Others				Eliminations				Total
(in thousands)
Cash Flows from Operating Activities
	Net increase (decrease) in net assets resulting from operations				$	228,291			$	(17,366	)		$	(1,385	)		$	18,751			$	228,291
	Adjustments
		Portfolio investments				(495,716	)			(10,660	)			—				—				(506,376	)
		Repayments of investment principal				134,049				9,118				—				—				143,167
		Proceeds from investment sales				207,291				—				6,183				—				213,474
		Change in accrued or reinvested interest and dividends				(41,589	)			(3,076	)			—				—				(44,665	)
		Net change in intercompany investments				(5,776	)			2,785				(2,534	)			5,525				—
		Amortization of discounts and fees				(19,448	)			(1,144	)			—				—				(20,592	)
		Changes in other assets and liabilities				7,747				1,005				(9,487	)			—				(735	)
		Depreciation and amortization				—				—				1,572				—				1,572
		Realized losses				40,417				6,436				3,772				—				50,625
		Net unrealized losses				571				21,875				2,401				(24,276	)			571
			Net cash provided by (used in) operating activities			55,837				8,973				522				—				65,332
Cash Flows from Financing Activities
	Sale of common stock					172,847				—				—				—				172,847
	Sale of common stock upon the exercise of stock options					12,136				—				—				—				12,136
	Collections of notes receivable from sale of common stock					3,706				—				—				—				3,706
	Common dividends and distributions paid					(220,411	)			—				—				—				(220,411	)
	Preferred stock dividends paid					—				(220	)			(10	)			—				(230	)
	Repayments on notes payable and debentures					(81,856	)			—				—				—				(81,856	)
	Net borrowings under revolving line of credit					59,500				—				—				—				59,500
	Other					(727	)			—				—				—				(727	)
			Net cash provided by (used in) financing activities			(54,805	)			(220	)			(10	)			—				(55,035	)
Net increase in cash and cash equivalents					$	1,032			$	8,753			$	512			$	—			$	10,297
Cash and cash equivalents at beginning of year						690				173				26				—				889
Cash and cash equivalents at end of year					$	1,722			$	8,926			$	538			$	—			$	11,186

F-46

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Independent Auditors’ Report

The Board of Directors and Shareholders
Allied Capital Corporation:

      We have audited the accompanying consolidated balance sheet of Allied Capital Corporation and subsidiaries, including the consolidated statement of investments, as of December 31, 2002, and the related consolidated statements of operations, changes in net assets and cash flows, and the financial highlights (included in Note 15), for the year then ended. 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 audit. The consolidated financial statements of Allied Capital Corporation and subsidiaries as of December 31, 2001, and for the years ended December 31, 2001 and 2000 were audited by other auditors who have ceased operations. Those auditors’ report, dated February 20, 2002, on those consolidated financial statements, was unqualified, before the revisions described in Notes 2 and 14 to the consolidated financial statements, and included an emphasis paragraph that described the Company’s method of valuing investments and the inherent uncertainty of valuation as discussed in Note 2 to the consolidated financial statements.

      We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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, 2002. 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 audit provides a reasonable basis for our opinion.

      In our opinion, the 2002 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, 2002, the results of their operations, their cash flows, changes in their net assets, and financial highlights for the year then ended, in conformity with accounting principles generally accepted in the United States of America.

      As discussed above, the consolidated financial statements of the Company as of December 31, 2001 and for the years ended December 31, 2001 and 2000 were audited by other auditors who have ceased operations. As described in Notes 2 and 14, those consolidated financial statements have been revised. We audited the revisions described in Notes 2 and 14 that were applied to the 2001 and 2000 consolidated financial statements. In our opinion, such revisions are appropriate and have been properly applied. However, we were not engaged to audit, review, or apply any procedures to the 2001 and 2000 consolidated financial statements of the Company other than with respect to such revisions, and, accordingly, we do not express an opinion or any other form of assurance on the 2001 and 2000 consolidated financial statements taken as a whole.

      Our audit was made for the purpose of forming an opinion on the 2002 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

F-47

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Washington, D.C.

F-48

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Independent Auditors’ Report

      NOTE: THIS IS A COPY OF A REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP, ALLIED CAPITAL CORPORATION’S FORMER INDEPENDENT ACCOUNTANTS. THIS REPORT HAS NOT BEEN REISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH FILING OF THE REGISTRATION STATEMENT OF WHICH THIS PROSPECTUS IS A PART.

To the Shareholders and Board of Directors of Allied Capital Corporation and Subsidiaries:

      We have audited the accompanying consolidated balance sheets of Allied Capital Corporation and subsidiaries as of December 31, 2001 and 2000, including the consolidated statement of investments as of December 31, 2001, and the related consolidated statements of operations, changes in net assets and cash flows for each of the three years in the period then ended, and the financial highlights (included in Note 15) for the year ended December 31, 2001. These consolidated financial statements, financial highlights and the supplementary consolidating financial information referred to below are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements, financial highlights and the supplementary consolidating financial information referred to below based on our audits.

      We conducted our audits in accordance with auditing standards generally accepted in the 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 investments. 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.

      As discussed in Note 2, the consolidated financial statements include investments valued at $2,329,590,000 as of December 31, 2001 and $1,788,001,000 as of December 31, 2000 (172 percent and 174 percent, respectively, of net assets) whose values have been estimated by the board of directors in the absence of readily ascertainable market values. However, because of the inherent uncertainty of valuation, the board of directors’ estimated 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.

      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, 2001 and 2000, and the consolidated results of their operations, changes in net assets and cash flows for each of the three years in the period then ended, and the financial highlights for the year ended December 31, 2001 in conformity with accounting principles generally accepted in the United States.

      Our audit was made for the purpose of forming an opinion on the consolidated financial statements taken as a whole. The supplementary 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 balance sheet, statement of operations and cash flows of the individual companies and are not a required part of the consolidated financial statements. This information has been subjected

F-49

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Vienna, Virginia

F-50

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2,200,000 Shares

Common Stock

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Deutsche Bank Securities	U.S. Bancorp Piper Jaffray

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