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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2003

Commission File No. 1-31753

CapitalSource Inc.

(800) 370-9431

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 period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

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

Indicate the number of shares outstanding of each of the issuer’s class of common stock, as of the latest practicable date:

CAPITALSOURCE INC.
TABLE OF CONTENTS

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CapitalSource Inc.
Consolidated Balance Sheets
($ in thousands)

See accompanying notes.

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CapitalSource Inc.
Consolidated Statements of Income
(Unaudited)
($ in thousands, except per share data)

See accompanying notes.

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CapitalSource Inc.
Consolidated Statement of Shareholders’ Equity
(Unaudited)
($ in thousands)

See accompanying notes.

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CapitalSource Inc.
Consolidated Statements of Cash Flows
(Unaudited)
($ in thousands)

See accompanying notes.

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CapitalSource Inc.
Notes to the Unaudited Consolidated Financial Statements

Note 1. Organization

CapitalSource Inc. (“CapitalSource”), a Delaware corporation, is a commercial finance company that provides a broad array of financial products to small and medium-sized businesses. CapitalSource provides the following products:

	•		Senior Secured Asset-Based Loans – loans secured by accounts receivable, inventory, equipment, and/or other assets;
	•		Senior Secured Cash Flow Loans – loans secured by a first priority lien on assets;
	•		First Mortgage Loans – non-traditional, short-term real estate loans;
	•		Mezzanine Loans – loans with subordinated lien positions; and
	•		Private Equity Co-Investments – opportunistic equity investments, typically in conjunction with lending relationships and on the same terms as other equity investors.

CapitalSource is the parent company of the following significant subsidiaries:

On August 6, 2003, CapitalSource became the successor to CapitalSource Holdings LLC (“CapitalSource Holdings”) through a reorganization. In the reorganization, a wholly owned subsidiary of CapitalSource merged with and into CapitalSource Holdings, with CapitalSource Holdings continuing as a wholly owned subsidiary of CapitalSource. As a result of the merger, the existing holders of units of membership interest in CapitalSource Holdings received, on a one-for-one basis, shares of CapitalSource common stock in exchange for their units, and the shares of CapitalSource common stock owned by CapitalSource Holdings were canceled.

On August 12, 2003, CapitalSource completed the sale of 23.43 million shares of common stock in our initial public offering. Of this amount, a total of 18.13 million shares were sold by us and 5.3 million shares were sold by selling stockholders. The closing included 2.13 million shares of common stock sold by us pursuant to the exercise of the underwriters’ over-allotment option. The initial public offering price was $14.50 per share. The aggregate sale price for all of the shares we sold was approximately $263 million, resulting in net proceeds to us, after payment of underwriting discounts, commissions, and other expenses of approximately $242 million. CapitalSource did not receive any proceeds from the shares sold by the selling stockholders. We used the net proceeds from the initial public offering to repay indebtedness under our credit facilities and one of our repurchase obligations.

Note 2. Summary of Significant Accounting Policies

Unaudited Interim Consolidated Financial Statements Basis of Presentation

Interim consolidated financial statements of CapitalSource are prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with GAAP are omitted. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the interim periods, have been included. The

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current period’s results of operations are not necessarily indicative of the results that ultimately may be achieved for the year. The interim unaudited consolidated financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto for the years ended December 31, 2002 and 2001 and the period from September 7, 2000 (inception) through December 31, 2000.

The accompanying financial statements reflect the consolidated accounts of CapitalSource, including all of its subsidiaries and the related consolidated results of operations with all significant intercompany balances eliminated.

New Accounting Pronouncements

Effective January 1, 2003, CapitalSource adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”). FIN 45 requires a guarantor to recognize a liability at the inception of the guarantee for the fair value of the obligation undertaken in issuing the guarantee and include more detailed disclosure with respect to guarantees. The types of contracts we enter into that meet the scope of this interpretation are standby letters of credit issued on behalf of borrowers. FIN 45 is effective for the guarantees issued or modified after December 31, 2002. The adoption of this accounting pronouncement did not have a material effect on our consolidated financial statements.

Effective July 1, 2003, CapitalSource adopted FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. FIN 46 also requires disclosures about variable interest entities that a company is not required to consolidate but in which it has a significant variable interest. The adoption of this accounting pronouncement did not have a material effect on our consolidated financial statements.

Note 3. Allowance for Loan Losses

Activity in the allowance for loan losses for the nine months ended September 30, 2003 and 2002 was as follows:

As of September 30, 2003, impaired loans totaled $11.5 million. Specific reserves for the impaired loans were $2.1 million as defined by SFAS No. 114, Accounting by Creditors for Impairment of a Loan. As of December 31, 2002, there were no impaired loans. Additionally, as of September 30, 2003, loans with an aggregate outstanding principal balance of $9.2 million were on non-accrual status.

For the nine months ending September 30, 2003, three loans with a carrying value of $33.0 million as of September 30, 2003 were classified as troubled debt restructurings as defined by SFAS No. 15, Accounting for Debtors and Creditors for Troubled Debt Restructurings. For the year ended December 31, 2002, there were no loans classified as troubled debt restructurings.

Note 4. Acquisition of Assets

On March 3, 2003, we purchased assets from another financial institution for a purchase price of approximately $174.8 million. The assets acquired included 55 loans with an aggregate principal balance of approximately $188.5 million. The loans comprised a well-seasoned portfolio and had a weighted average remaining life of approximately 14 months at acquisition. Additionally, we purchased furniture and equipment from the seller, assumed the seller’s office lease of 3,792 square feet located in a suburb of Dallas, and added nine former employees of the seller who were responsible for managing the acquired assets, including five auditors, three loan officers and a development officer. The office lease has been renegotiated and extended through June 26, 2006 at a monthly rental expense of approximately $7,500.

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We considered Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations, and EITF 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business, to determine if the assets acquired constituted a business. Since all but a de minimis amount of the fair value of the transferred set of activities and assets is represented by a single tangible asset, the loan portfolio, the concentration of value in the single asset is an indicator that an asset rather than a business was purchased. Therefore, we have accounted for the acquisition of loans in accordance with SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, by expensing the costs associated with the acquisition.

Note 5. Borrowings

Repurchase Obligation

In August 2003, CapitalSource entered into a $300 million master repurchase agreement with an affiliate of Credit Suisse First Boston LLC (“CSFB”) to finance healthcare mortgage loans. This repurchase agreement will allow us to sell mortgage loans that we originate to CSFB for a purchase price equal to 70% of the outstanding principal balance of those mortgage loans, and we will have the obligation to repurchase the loans no later than 18 months after the sale. Our obligation to repurchase loans may be accelerated if an event of default under one or more of our purchased mortgage loans occurs and under certain other conditions, such as a breach of our representations or warranties under the repurchase agreement. During the time a mortgage loan is owned by CSFB, we will pay CSFB an annual rate of LIBOR plus 1.25% the amount advanced to us on the mortgage loan. The repurchase agreement is scheduled to terminate on July 31, 2008, and at that time we will be required to repurchase any mortgage loans not previously repurchased. In addition, at any time prior to expiration of the repurchase agreement, CSFB may give notice of its intention to terminate the repurchase agreement and require us to repurchase all outstanding mortgage loans on the date which is 364 days from such notice of termination. As of September 30, 2003, no amount was outstanding under the CSFB repurchase agreement.

Credit Facility

In September 2003, CapitalSource entered into a $400 million credit facility with an affiliate of Citigroup Global Markets Inc. (“Citigroup”) to finance our loans. The credit facility permits us to obtain financing of up to 75% of the outstanding principal balance of commercial loans we originate and transfer to this facility, depending upon their current loan rating and priority of payment within the particular borrower’s capital structure and subject to certain concentration limits. During the time a commercial loan is subject to the credit facility, we will pay Citigroup a percentage equal to an annual rate of LIBOR plus 1.00% applied to the amount advanced to us on the commercial loan. The credit facility has an initial term of 364 days and is renewable by mutual agreement with Citigroup. As of September 30, 2003, the outstanding balance under the Citigroup credit facility was $65.1 million.

Note 6. Shareholders’ Equity

From September 7, 2000 (inception) through August 30, 2002, there were three classes of interests in CapitalSource Holdings: preferred interests, common interests and employee units. On August 30, 2002, CapitalSource Holdings completed a recapitalization, pursuant to which all preferred interests and employee units were converted into common interests (“Units”). The recapitalization transferred ownership interests from the preferred interests holders to the holders of common interest and employee units, eliminated certain preferred return provisions to the preferred interest holders, and reduced the capital commitments of the members from $542.4 million to $511.0 million.

During the period from January 1, 2003 to August 6, 2003, members contributed capital of $71.2 million and we paid distributions of $32.7 million to members.

On August 6, 2003, CapitalSource became the successor to CapitalSource Holdings through a reorganization. In the reorganization, the existing holders of units of membership interests in CapitalSource Holdings received, on a one-for-one basis, shares of CapitalSource common stock in exchange for their units, and the shares of CapitalSource common stock owned by CapitalSource Holdings were canceled.

Employee Stock Purchase Plan

Effective with CapitalSource’s initial public offering on August 6, 2003, the Board of Directors and stockholders of CapitalSource adopted the CapitalSource Inc. Employee Stock Purchase Plan. A total of 2.0 million shares of common stock are reserved for issuance under the plan. Such shares of common stock may be authorized but unissued shares of common stock, treasury shares or shares of common stock purchased on the open market by CapitalSource. The plan will expire upon the

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earliest of such time as the Board, in its discretion, chooses to terminate the plan, when all of the shares of common stock have been issued under the plan or upon the expiration of ten years from the effective date of the plan.

Equity Incentive Plan

Effective with CapitalSource’s initial public offering on August 6, 2003, the Board of Directors and stockholders of CapitalSource adopted the CapitalSource Inc. Second Amended and Restated Equity Incentive Plan (the “Plan”). A total of 14.0 million shares of common stock are reserved for issuance under the Plan. The Plan will expire on the earliest of (1) the date as of which the Board of Directors, in it sole discretion, determines that the Plan shall terminate, (2) following certain corporate transactions such as a merger or sale of CapitalSource Inc.’s assets if the Plan is not assumed by the surviving entity, (3) at such time as all shares of common stock that may be available for purchase under the Plan have been issued or (4) ten years after the effective date of the Plan. The Plan is intended to give eligible employees, members of the Board of Directors, consultants and advisors of CapitalSource Inc. and its affiliates awards that are linked to the performance of CapitalSource Inc.’s common stock.

Note 7. Income Taxes

The effective tax rate differed from the statutory federal corporate income tax rate as follows:

Note 8. Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) relates to the unrealized gain (loss) on available-for-sale security for the three and nine months ended September 30, 2003 and 2002 was as follows ($ in thousands):

Comprehensive income for the three and nine months ended September 30, 2003 was $31,295 and $78,243, respectively. Comprehensive income for the three and nine months ended September 30, 2002 equaled net income.

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Note 9. Net Income per Share

The computation of basic and diluted net income per share for the three and nine months ended September 30, 2003 and 2002 was as follows ($ in thousands, except per share data):

(1)  Adjusted to reflect the recapitalization that took place on August 30, 2002 as if it occurred on January 1, 2002. For additional description of the recapitalization, see note 6.

Note 10. Employee Incentive Plan

CapitalSource accounts for its stock-based compensation plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The following table illustrates the effect on net income and net income per share if CapitalSource had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based compensation ($ in thousands, except per share data):

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The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

Note 11. Guarantees

As of September 30, 2003, CapitalSource had arranged for $51.0 million of standby letters of credit in conjunction with certain loans to its borrowers. If a borrower defaults on its commitment(s) subject to any letter of credit issued under these arrangements, CapitalSource would be responsible to meet the borrower’s financial obligation and would seek repayment of that financial obligation from the borrower. In accordance with FIN 45, CapitalSource included the fair value of these obligations, totaling $1.8 million, in the Consolidated Balance Sheet as of September 30, 2003.

Note 12. Subsequent Event

In October 2003, CapitalSource sold an equity investment in MedCap Properties LLC for cash consideration of $16.1 million, generating an estimated pretax gain of $14.0 million.

Pursuant to the terms of the sale, approximately $2.1 million of additional proceeds is currently being held on behalf of CapitalSource in an indemnity escrow account until March 31, 2005 to cover certain defined potential future liabilities. The receipt of any or all of these proceeds is contingent upon future events which are beyond CapitalSource’s control.

Additionally, a special-purpose limited liability company was created in this transaction, and CapitalSource retains an equity interest in that entity which had a carrying value of $2.1 million as of October 2, 2003.

CapitalSource will incur additional expenses related to the gain generated by this sale transaction, including an increase in bonus compensation.

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

The information contained in this section should be read in conjunction with our unaudited consolidated financial statements and related notes.

Overview

We are a specialized commercial finance company providing loans to small and medium-sized businesses. Our goal is to be the lender of choice for small and medium-sized businesses with annual revenues ranging from $5 million to $250 million that require customized and sophisticated debt financings. We conduct our business in one reportable segment through three focused lending groups:

	•		Corporate Finance, which provides senior and mezzanine loans principally to businesses backed by private equity sponsors;
	•		HealthCare Finance, which provides asset-based revolving lines of credit, mortgage, and other secured loans to a broad range of healthcare companies; and
	•		Structured Finance, which provides asset-based lending to finance companies and commercial real estate owners.

We offer a range of senior secured asset-based loans, first mortgage loans, senior-secured cash flow loans and mezzanine loans to our clients. Our loans generally mature in two to five years and range in size from $1 million to $50 million. Virtually all of our loans require monthly interest payments at floating rates. In many cases, our loans provide for interest rate floors that help us maintain our yields when interest rates are low or declining. As of September 30, 2003, $1.4 billion, or 69%, of the aggregate outstanding principal amount of our loan portfolio had interest rate floors. Of this amount, loans representing 99.2% of the outstanding principal amount of the loans with interest rate floors bore interest at the interest rate floor as of September 30, 2003.

Our revenue consists of interest and fees from our loans and, to a lesser extent, other income which includes unrealized appreciation (depreciation) on certain equity interests and gains (losses) on the sale of warrants and other equity interests. Our expenses consist of interest expense and operating expenses which include compensation and employee benefits and other administrative expenses.

The primary driver of our results of operations and financial condition has been our significant growth since our inception on September 7, 2000. Our interest earning assets, which consist primarily of loans, grew from $1.2 billion to $2.1 billion, or 75%, from December 31, 2002 to September 30, 2003 and generated a gross yield of 12.01% for the nine months ended September 30, 2003.

We believe that our rapid growth has not adversely affected the credit quality of our portfolio. We have not recorded a loan charge off since inception. As of September 30, 2003, one of our first mortgage loans was 60 or more days delinquent. As of that date, the approximate outstanding principal amount of the loan was $4.8 million and the delinquent amount was less than $0.2 million. Additionally, as of September 30, 2003, loans with an aggregate outstanding principal balance of $9.2 million were on non-accrual status. We expect to experience credit losses in the future and have established an allowance for loan losses consistent with our expectation of losses inherent in our portfolio.

Like all lenders our business depends on our access to external sources of financing and the cost of such funding. Since inception, we have funded our business through a combination of credit facilities, term debt, repurchase obligations, $511 million of equity capital raised from private investors, $247 million of equity raised from our initial public offering and retained earnings. The interest cost of our borrowings for the nine months ended September 30, 2003 was 3.26%. Our term debt comprises securitization transactions all of which have been accounted for as on balance sheet financings with no gain or loss recorded on the transactions. As of September 30, 2003, our debt to equity ratio was 1.53x. We believe that our capital structure and access to additional funding sources provide us with the flexibility to continue to grow our assets as we pursue attractive lending opportunities.

We accelerated our investments in our staffing and other operational assets during our first years in operation. As a result, we believe our expenses will continue to decrease as a percentage of our average total assets as we continue to carefully control our operating expenses and spread these expenses over a growing portfolio of loans. For the nine months ended September 30, 2003, the ratio of our operating expenses to average total assets was 3.49%, down from 4.54% for the nine months ended September 30, 2002.

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