ALLIED CAPITAL CORP - 10-Q Quarterly Report

FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

QUARTERLY REPORT PURSUANT TO

SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934


For The Quarterly Period Ended June 30, 2003		Commission File Number: 0-22832

ALLIED CAPITAL CORPORATION

(Exact Name of Registrant as Specified in its Charter)



Maryland (State or Jurisdiction of Incorporation or Organization)		52-1081052 (IRS Employer Identification No.)

1919 Pennsylvania Avenue, N.W.

Washington, DC 20006

(Address of Principal Executive Offices)

Registrant’s telephone number, including area code: (202) 331-1112

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods as the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) YES x NO o

On July 30, 2003, there were 116,495,473 shares outstanding of the Registrant’s common stock, $0.0001 par value.

ALLIED CAPITAL CORPORATION

FORM 10-Q INDEX


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		Consolidated Balance Sheet as of June 30, 2003 (unaudited) and December 31, 2002	1
		Consolidated Statement of Operations (unaudited) — For the Three and Six Months Ended June 30, 2003 and 2002	2
		Consolidated Statement of Changes in Net Assets (unaudited) — For the Six Months Ended June 30, 2003 and 2002	3
		Consolidated Statement of Cash Flows (unaudited) — For the Six Months Ended June 30, 2003 and 2002	4
		Consolidated Statement of Investments as of June 30, 2003 (unaudited)	5
		Notes to Consolidated Financial Statements	16
		Independent Accountants’ Review Report	36
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		37
	Item 3. Quantitative and Qualitative Disclosures about Market Risk		72
	Item 4. Controls and Procedures		72

PART II. OTHER INFORMATION
	Item 1. Legal Proceedings		73
	Item 2. Changes in Securities and Use of Proceeds		73
	Item 3. Defaults Upon Senior Securities		73
	Item 4. Submission of Matters to a Vote of Security Holders		73
	Item 5. Other Information		73
	Item 6. Exhibits and Reports on Form 8-K		74
	Signatures		78

PART I: FINANCIAL INFORMATION

Item 1. 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.

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.

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.

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.

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.

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



			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.

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



			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.

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



			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.

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



			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.

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



			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.

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



			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.

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



			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.

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



			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.

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



								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.

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



			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.

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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Information at and for the six months ended June 30, 2003 and 2002 is unaudited)

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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 2. Summary of Significant Accounting Policies, 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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 2. Summary of Significant Accounting Policies, continued

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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 2. Summary of Significant Accounting Policies, 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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 2. Summary of Significant Accounting Policies, continued

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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 2. Summary of Significant Accounting Policies, 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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, 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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, continued

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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, 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	%

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, 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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, continued

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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, 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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, 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	%

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 3. Portfolio, 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	%


⁽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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 4. Debt, 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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 4. Debt, 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.

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 9. Dividends and Distributions, 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,

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 11. Hedging Activities, 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	)%

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

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 12. Financial Highlights, 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

⁽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.

Independent Accountants’ Review Report

The Board of Directors and Shareholders

Allied Capital Corporation and Subsidiaries:

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.

July 28, 2003


Item 2.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*

The following analysis of the financial condition and results of operations of the Company should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes thereto included herein and in the Company’s annual report on Form 10-K for the year ended December 31, 2002. This quarterly report on Form 10-Q 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;

• future changes in laws or regulations and conditions in our operating areas; and

• other risks and uncertainties as may be detailed from time to time in our public announcements and SEC filings.

Financial or other information presented for private finance portfolio companies has been obtained from the portfolio 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.

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.

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.

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. Control investments provide the opportunity to invest meaningful amounts of

capital with the potential for attractive current income returns as well as the potential for future capital gains. Control transactions are typically larger than our mezzanine investments. In some cases for companies that are more than 50% owned, we may not accrue interest on loans and debt securities if such company is in need of additional working capital. In such cases, we may defer current debt service. Our most significant investments acquired through control buyout transactions at June 30, 2003, were Business Loan Express, LLC (BLX), acquired in 2000, and The Hillman Companies, Inc., acquired in 2001.

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.

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 with the AIF acquisition and the LLC reorganization, as well as by $1.3 million because of the increased value of issued and outstanding equity appreciation rights to employees. Adding back these acquisition and

reorganization costs, and expenses due to equity appreciation rights, BLX’s EBITM increased by 11.6% on a comparative twelve month basis. BLX’s revenues consist of cash premiums from guaranteed loan sales, gain on sale income arising from loans sold at par or securitized where BLX will receive future cash flows representing the spread between loan interest and the interest paid on bonds issued including service fee income, interest income on loans remaining in BLX’s portfolio, and other income. Gain on sale income is a non-cash source of income when recognized, and as future cash flows are received, the resulting cash reduces the receivable or residual interest that is recognized when the loan is sold. The total of cash loan sale premiums, cash interest income and cash received from residual interests and other cash income is equal to approximately 77% of BLX’s revenue of $109.1 million during the twelve months ended June 30, 2003.

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 twelve months ended June 30, 2003, BLX received cash payments from securitization pools of approximately $43.2 million.

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.

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

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


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

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%, 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 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.

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.

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.

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 average yield on the interest-bearing investments in the portfolio at June 30, 2003 and 2002, was as follows:


($ 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 debentures and our revolving line of credit.

Our borrowing activity and weighted average interest cost, including fees and closing costs, were as follows:



	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.

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 private finance portfolio companies, including Woodstream Corporation ($6.6 million), Kirkland’s Inc. ($1.8 million), and

Interline Brands, Inc. ($1.7 million). For the three months ended June 30, 2003 and 2002, we reversed previously recorded unrealized appreciation totaling $7.9 million and $2.1 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.

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. 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.

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 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 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. In arriving at the value of our investment, we estimated that the total enterprise value of BLX increased from $407 million at March 31, 2003, to $465 million at June 30, 2003. This results in a total value of the Class B and Class C equity interests of $262.7 million at June 30, 2003, as compared to a total value for the Class B and Class C equity interests of $207.2 million at March 31, 2003, or an increase of 27%.

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, 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.

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.

$1,796.5 million at June 30, 2002. The weighted average yield on the interest-bearing investments in the portfolio at June 30, 2003 and 2002, was as follows:


($ 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 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 our revolving line of credit.

Our borrowing activity and weighted average interest cost, including fees and closing costs, were as follows:



	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.

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. ($8.4 million), CyberRep ($8.3 million), Woodstream Corporation ($6.6 million), Blue Rhino Corporation ($3.9 million), Kirkland’s Inc. ($3.0 million), GC-Sun Holdings II, LP ($2.5 million), and Interline Brands, Inc. ($1.7 million). In addition, gains were also realized on CMBS bonds ($24.6 million, net of a realized loss of $6.7 million from hedges related to the CMBS bonds sold). For the six months ended June 30, 2003 and 2002, we reversed previously recorded unrealized appreciation totaling $50.8 million and $7.3 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.

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 manage to a low cash balance and fund new originations with our revolving line of credit, and through the issuance of debt and equity securities.

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%


⁽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.

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

⁽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.

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 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. Enterprise value means the entire value of the company to a potential buyer, including the sum of the values of debt and equity securities used to capitalize the enterprise at a point in time. We will record unrealized appreciation if we believe that the underlying portfolio company has appreciated in value and, therefore, our equity security has also appreciated in value. The value of investments in publicly traded securities 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 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.

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.

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.

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.

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.

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 June 30, 2003, 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 process for the types of investments we make. Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses; we are instead required by the 1940 Act to specifically value each individual investment on a quarterly basis 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 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. 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 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 change in unrealized appreciation or depreciation.

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 an accompanying equity feature. We cannot be sure that our portfolio will generate a current return or capital gains.

Our financial results could be negatively affected if Business Loan Express fails to perform as expected. Business Loan Express, LLC (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 June 30, 2003, the investment totaled $356.8 million at value, or 12.6% of total assets.

In addition, as controlling equity owner 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 $164.0 million revolving credit facility. The amount we have guaranteed at June 30, 2003, was $53.6 million. This guaranty can only be called in the event of a default by BLX. We have also provided three standby letters of credit in connection with three term securitization transactions completed by BLX totaling $25.6 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 June 30, 2003, our asset coverage for senior indebtedness was 286%.

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 consolidated income in excess of consolidated interest payable on the borrowed funds would cause our net income to increase more than it would without the leverage, while any decrease in our consolidated income would cause net income to decline more sharply than it would have had we not borrowed. Such a decline could negatively affect our ability to make common stock dividend payments. Leverage is generally considered a speculative investment technique.

At June 30, 2003, we had $979.7 million of outstanding indebtedness, bearing a weighted average annual interest cost of 7.4%. In order for us to cover these annual interest payments on indebtedness, we must achieve annual returns on our assets of at least 2.6%.

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 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 growth in our investments. Historically, we have borrowed from financial institutions and have issued equity securities. A reduction in the availability of new capital could limit our ability to grow. We must distribute at least 90% of our taxable ordinary income, which excludes net realized long-term capital gains, to our shareholders to maintain our regulated investment company status. As a result, such earnings will not be available to fund investment originations. We expect to continue to borrow from financial institutions and issue additional debt and equity securities. If we fail to obtain funds from such sources or from other sources to fund our investments, it could limit our ability to grow, which could have a material adverse effect on the value of our common stock. In addition, as a business development company, we are generally required to maintain a ratio of at least 200% of total assets to total borrowings, which may restrict our ability to borrow in certain circumstances.

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. 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 banks and other equity and non-equity based investment funds, and other sources of financing, including traditional financial services companies such as commercial banks. Some of our competitors have greater resources than we do. Increased competition would make it more difficult for us to purchase or originate investments at attractive prices. As a result of this competition, sometimes we may be precluded from making otherwise attractive investments.

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 may 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 net 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 the 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.

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.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There has been no material change in quantitative or qualitative disclosures about market risk since December 31, 2002.

Item 4. Controls and Procedures

(a) As of the end of the period covered by this quarterly report on Form 10-Q, the Company’s chief executive officer and chief financial officer conducted an evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934). Based upon this evaluation, the Company’s chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them of any material information relating to the Company that is required to be disclosed by the Company in the reports it files or submits under the Securities Exchange Act of 1934.

(b) There have been no changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2003, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. 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 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.

Item 2. Changes in Securities and Use of Proceeds

During the three months ended June 30, 2003, we issued a total of 70,485 shares of common stock under our dividend reinvestment plan pursuant to an exemption from the registration requirements of the Securities Act of 1933. The aggregate offering price for the shares of common stock sold under the dividend reinvestment plan was approximately $1.6 million.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

On May 13, 2003, we held our Annual Meeting of Shareholders in Washington, DC. Shareholders voted on two matters; the substance of these matters and the results of the voting of each such matter are described below. There were no broker non-votes for items 1 and 2 below.

1. Election of Directors: Shareholders elected four directors of the Company, who will serve for three years, or until their successors are elected and qualified. Votes were cast as follows:


	For		Withheld

Ann Torre Grant		101,618,275		1,165,261
John I. Leahy		101,661,594		1,121,942
Alex J. Pollock		101,752,823		1,030,713
Guy T. Steuart II		96,455,856		6,327,680

The following directors are continuing as directors of the Company for their respective terms - William L. Walton, Brooks H. Browne, John D. Firestone, Anthony T. Garcia, Lawrence I. Hebert, Laura W. van Roijen, Robert E. Long, and George C. Williams, Jr.

2. Ratification of the selection of KPMG LLP to serve as independent public accounts for the year ending December 31, 2003. Votes were cast as follows:


For		Against		Abstain

	101,681,526		704,400		397,610

Item 5. Other Information

Not applicable.

Item 6. Exhibits and Reports on Form 8-K

(a) List of Exhibits


Exhibit
Number		Description

	3.1	Restated Articles of Incorporation. (Incorporated by reference to Exhibit a.1 filed with Allied Capital’s Post-Effective Amendment No. 2 to registration statement on Form N-2 (File No. 333-67336) filed on March 22, 2002).
	3.2	Amended and Restated Bylaws. (Incorporated by reference to Exhibit b. filed with Allied Capital’s Post-Effective Amendment No. 2 to registration statement on Form N-2 (File No. 333-67336) filed on March 22, 2002).
	4.1	Specimen Certificate of Allied Capital’s Common Stock, par value $0.0001 per share. (Incorporated by reference to Exhibit d. filed with Allied Capital’s registration statement on Form N-2 (File No. 333-51899) filed on May 6, 1998).
	4.2	Form of debenture between certain subsidiaries of Allied Capital and the U.S. Small Business Administration. (Incorporated by reference to Exhibit 4.2 filed by a predecessor entity to Allied Capital on Form 10-K for the year ended December 31, 1996).
	10.1	Dividend Reinvestment Plan, as amended. (Incorporated by reference to Exhibit e. filed with Allied Capital’s registration statement on Form N-2 (File No. 333-87862) filed on May 8, 2002).
	10.2	Third Amended and Restated Credit Agreement, dated April 18, 2003. (Incorporated by reference to Exhibit 10.2 filed with Allied Capital’s Form 10-Q for the period ended March 31, 2003).
	10.3	Note Agreement, dated as of April 30, 1998. (Incorporated by reference to Exhibit 10.2 filed with Allied Capital’s Form 10-Q for the period ended June 30, 1998).
	10.4	Loan Agreement between a predecessor entity to Allied Capital and Overseas Private Investment Corporation, dated April 10, 1995. (Incorporated by reference to Exhibit f.7 filed by a predecessor entity to Allied Capital to Pre-Effective Amendment No. 2 to registration statement on Form N-2 (File No. 333-64629) filed on January 24, 1996). Letter, dated December 11, 1997, evidencing assignment of Loan Agreement from the predecessor entity of Allied Capital to Allied Capital. (Incorporated by reference to Exhibit 10.3 to Allied Capital’s Form 10-K for the year ended December 31, 1997).
	10.5	Note Agreement, dated as of May 1, 1999. (Incorporated by reference to Exhibit 10.5 filed with Allied Capital Form 10-Q for the period ended June 30, 1999).
	10.6	Amendment and Consent Agreement, dated December 11, 2000, to the Amended and Restated Credit Agreement, dated May 17, 2000. (Incorporated by reference to Exhibit f.6 filed with Allied Capital’s Post-Effective Amendment No. 2 to the registration statement on Form N-2 (File No. 333-43534) filed on March 21, 2001).
	10.7	Sale and Servicing Agreement, dated as of January 1, 1998, among Allied Capital CMT, Inc., Allied Capital Commercial Mortgage Trust 1998-1, Allied Capital Corporation, LaSalle National Bank and ABN AMRO Bank N.V. (Incorporated by reference to Exhibit f.7.a filed with Allied Capital’s registration statement on Form N-2 (File No. 333-51899) filed on May 6, 1998).
	10.8	Indenture, dated as of January 1, 1998, between Allied Capital Commercial Mortgage Trust 1998-1 and LaSalle National Bank. (Incorporated by reference to Exhibit f.7.b filed with Allied Capital’s registration statement on Form N-2 (File No. 333-51899) filed on May 6, 1998).


Exhibit
Number		Description

	10.9	Amended and Restated Trust Agreement, dated January 1, 1998, between Allied Capital CMT, Inc., LaSalle National Bank Inc. and Wilmington Trust Company. (Incorporated by reference to Exhibit f.7.c filed with Allied Capital’s registration statement on Form N-2 (File No. 333-51899) filed on May 6, 1998).
	10.10	Guaranty, dated as of January 1, 1998, by Allied Capital. (Incorporated by reference to Exhibit f.7.d filed with Allied Capital’s registration statement on Form N-2 (File No. 333-51899) filed on May 6, 1998).
	10.11	Note Agreement, dated as of November 15, 1999. (Incorporated by reference to Exhibit 10.4a of Allied Capital’s Form 10-K for the year ended December 31, 1999).
	10.12	Note Agreement, dated as of October 15, 2000. (Incorporated by reference to Exhibit 10.4b filed with Allied Capital’s Form 10-Q for the period ended September 30, 2000).
	10.13	Note Agreement, dated as of October 15, 2001. (Incorporated by reference to Exhibit f.10 filed with Allied Capital’s Post-Effective Amendment No. 1 to registration statement on Form N-2 (File No. 333-67336) filed on November 14, 2001).
	10.15	Control Investor Guaranty Agreement, dated as of March 28, 2001, between Allied Capital and Fleet National Bank and Business Loan Express, Inc. (Incorporated by reference to Exhibit f.14 filed with Allied Capital’s Post-Effective Amendment No. 3 to registration statement on Form N-2 (File No. 333-43534) filed on May 15, 2001).
	10.16	Amended and Restated Deferred Compensation Plan, dated December 30, 1998. (Incorporated by reference to Exhibit 10.11 to Allied Capital’s Form 10-K for the year ended December 31, 1998).
	10.17	Amended to Deferred Compensation Plan, dated October 18, 2000. (Incorporated by reference to Exhibit i.2.a filed with Allied Capital’s Post-Effective Amendment No. 1 to registration statement on Form N-2 (File No. 333-43534) filed on January 19, 2001).
	10.18	Amended and Restated Deferred Compensation Plan, dated May 15, 2001. (Incorporated by reference to Exhibit i.2.b filed with Allied Capital’s Post-Effective Amendment No. 1 to registration statement on Form N-2 (File No. 333-67336) filed on November 14, 2001).
	10.19	Amended Stock Option Plan. (Incorporated by reference to Exhibit A of Allied Capital’s definitive proxy statement for Allied Capital’s 2002 Annual Meeting of Stockholders filed on April 3, 2002).
	10.20(a)	Allied Capital Corporation 401(k) Plan, dated September 1, 1999. (Incorporated by reference to Exhibit 4.4 filed with Allied Capital’s registration statement on Form S-8 (File No. 333-88681) filed on October 8, 1999).
	10.20(b)	Amendment to Allied Capital Corporation 401(k) Plan, dated December 31, 2000. (Incorporated by reference to Exhibit i.5.a filed with Allied Capital’s Post-Effective Amendment No. 1 to registration statement on Form N-2 (File No. 333-43534) filed on January 19, 2001).
	10.21	Employment Agreement, dated June 15, 2000, between Allied Capital and William L. Walton. (Incorporated by reference to Exhibit f.9 filed with Allied Capital’s registration statement on Form N-2 (File No. 333-43534) filed on August 11, 2000).
	10.22	Employment Agreement, dated June 15, 2000, between Allied Capital and Joan M. Sweeney. (Incorporated by reference to Exhibit f.10 filed with Allied Capital’s registration statement on Form N-2 (File No. 333-43534) filed on August 11, 2000).
	10.23	Employment Agreement, dated June 15, 2000, between Allied Capital and John M. Scheurer. (Incorporated by reference to Exhibit i.8 filed with Allied Capital’s Post-Effective Amendment No. 2 to registration statement on Form N-2 (File No. 333-43534) filed on March 21, 2001).


Exhibit
Number		Description

	10.24	Employment Agreement, dated June 15, 2002, between Allied Capital and Thomas H. Westbrook and amended as of March 10, 2003. (Incorporated by reference to Exhibit 10.24 filed with Allied Capital’s Form 10-K for the year ended December 31, 2002).
	10.25	Form of Custody Agreement with Riggs Bank N.A. (Incorporated by reference to Exhibit j.1 filed with Allied Capital’s registration statement on Form N-2 (File No. 333-51899) filed on May 6, 1998).
	10.26	Form of Custody Agreement with LaSalle National Bank. (Incorporated by reference to Exhibit j.2 filed with Allied Capital’s registration statement on Form N-2 (File No. 333- 51899) filed on May 6, 1998).
	10.27	Custodian Agreement with LaSalle National Bank Association dated July 9, 2001. (Incorporated by reference to Exhibit j.3 filed with Allied Capital’s registration statement on Form N-2 (File No. 333-67336) filed on August 10, 2001).
	10.28	Code of Ethics. (Incorporated by reference to Exhibit r. filed with Allied Capital’s Pre-Effective Amendment No. 1 to the registration statement on Form N-2 (File No. 333-43534) on September 12, 2000).
	10.30	Agreement and Plan of Merger by and among Allied Capital, Allied Capital Lock Acquisition Corporation, and Sunsource, Inc dated June 18, 2001. (Incorporated by reference to Exhibit k.1 filed with Allied Capital’s registration statement on Form N-2 (File No. 333-67336) filed on August 10, 2001).
	10.31	Note Agreement, dated as of May 14, 2003. (Incorporated by reference to Exhibit 10.31 filed with Allied Capital’s Form 10-Q for the period ended March 31, 2003).
	10.32	Amendment, dated as of April 30, 2003, to Note Agreement, dated as of April 30, 1998. (Incorporated by reference to Exhibit 10.32 filed with Allied Capital’s Form 10-Q for the period ended March 31, 2003).
	10.33	Amendment, dated as of April 30, 2003, to Note Agreement, dated as of May 1, 1999. (Incorporated by reference to Exhibit 10.33 filed with Allied Capital’s Form 10-Q for the period ended March 31, 2003).
	10.34	Amendment, dated as of April 30, 2003, to Note Agreement, dated as of November 15, 1999. (Incorporated by reference to Exhibit 10.34 filed with Allied Capital’s Form 10-Q for the period ended March 31, 2003).
	10.35	Amendment, dated as of April 30, 2003, to Note Agreement, dated as of October 15, 2000. (Incorporated by reference to Exhibit 10.35 filed with Allied Capital’s Form 10-Q for the period ended March 31, 2003).
	10.36	Amendment, dated as of April 30, 2003, to Note Agreement, dated as of October 15, 2001. (Incorporated by reference to Exhibit 10.36 filed with Allied Capital’s Form 10-Q for the period ended March 31, 2003).
	15.*	Letter regarding Unaudited Interim Financial Information
	31.1*	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Act of 1934.
	31.2*	Certification of Chief Financial Officer Pursuant Rule 13a-14(a) or 15d-14(a) under the Securities Act of 1934.
	32.1*	Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	32.2*	Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

* Filed herewith.

(b) Reports on Form 8-K

On April 18, 2003, we filed a Form 8-K pursuant to Item 12 reporting the issuance of a press release announcing that we had declared a dividend for the second quarter of 2003.

On April 22, 2003, we filed a Form 8-K pursuant to Item 12 reporting the issuance of a press release announcing our financial results for the quarter ended March 31, 2003.

On April 24, 2003, we filed a Form 8-K pursuant to Item 5 reporting the issuance of a press release announcing that the United States District Court for the Southern District of New York had dismissed a consolidated securities class action lawsuit against us and certain of our officers.

On July 21, 2003, we filed a Form 8-K pursuant to Item 9 reporting the issuance of a press release announcing that we had declared a dividend for the third quarter of 2003.

On July 29, 2003, we filed a Form 8-K pursuant to Item 12 reporting the issuance of a press release announcing our financial results for the quarter ended June 30, 2003.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.

ALLIED CAPITAL CORPORATION

(Registrant)



Dated: July 31, 2003		/s/ WILLIAM L. WALTON --------------------------------------------------- William L. Walton Chairman and Chief Executive Officer /s/ PENNI F. ROLL --------------------------------------------------- Penni F. Roll Chief Financial Officer

EXHIBIT INDEX


Exhibit
Number		Description

	15.*	Letter regarding Unaudited Interim Financial Information
	31.1*	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
	31.2*	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
	32.1*	Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	32.2*	Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


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


⁽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.


	•	the ongoing global economic downturn;

	•	risks associated with possible disruption in our operations due to terrorism;

	•	future changes in laws or regulations and conditions in our operating areas; and

	•	other risks and uncertainties as may be detailed from time to time in our public announcements and SEC filings.


⁽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.


⁽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.


	•	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.