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SECURITIES AND EXCHANGE COMMISSION

FORM 10-K
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2002

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

For the Transition Period From                      to                     .

Commission File Number: 1-09589

PMC CAPITAL, INC.

Securities registered pursuant to Section 12(b) of the Act:
Common stock, $.01 par value

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. YES x NO o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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

The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on June 28, 2002 as reported on the American Stock Exchange, was approximately $63 million. Common Stock held by each officer and director and by each person who owns 10% or more of the outstanding Common Stock has been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 21, 2003, the Registrant had 11,853,516 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after the year covered by this Form 10-K with respect to the Annual Meeting of Shareholders are incorporated by reference into Part III.

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PMC CAPITAL, INC.

Form 10-K
For the Year Ended December 31, 2002

TABLE OF CONTENTS

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PART I

Item 1. BUSINESS

INTRODUCTION

     PMC Capital, Inc., a Florida corporation, is a diversified, closed-end management investment company that has elected to operate as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). PMC Capital, Inc. (“PMC Capital” or “PMC,” and together with its consolidated subsidiaries, the “Company,” “we” or “our”) is a national lender to small businesses either directly or through our three 1940 Act subsidiaries. These subsidiaries are First Western SBLC, Inc. (“First Western”), PMC Investment Corporation (“PMCIC”) and Western Financial Capital Corporation (“Western Financial”). First Western, PMCIC and Western Financial are registered under the 1940 Act as diversified, closed-end management investment companies. PMC Capital’s common stock (the “Common Stock”) is traded on the American Stock Exchange under the symbol “PMC.” Our investment objective is to achieve current income that is available to pay out to shareholders in the form of quarterly dividends. PMC Capital has elected to be taxed as a regulated investment company under the Internal Revenue Code of 1986, as amended (the “Code”) and thus distributes substantially all of its taxable income as dividends to its shareholders, thereby incurring no Federal income tax liability on such income.

     Our operations are centralized in Dallas, Texas and include originating, servicing and selling commercial loans. We also have business development offices in Georgia, Arizona and Missouri. We operate under several licenses from the Small Business Administration (the “SBA”). First Western is licensed as a small business lending company (“SBLC”) that originates loans through the SBA’s 7(a) Guaranteed Loan Program. PMCIC is a licensed specialized small business investment company (“SSBIC”) under the Small Business Investment Act of 1958, as amended (“SBIA”). PMCIC uses long-term funds provided by the SBA, together with its own capital, to provide long-term collateralized loans to eligible small businesses owned by “disadvantaged” persons, as defined under SBA regulations. Western Financial is a licensed small business investment company (“SBIC”) under the SBIA that provides loans to borrowers whether or not they qualify as “disadvantaged.”

     PMC Capital is either directly or indirectly the sole shareholder or a partner of several non-investment company subsidiaries: PMC Advisers, Ltd. and its subsidiary (“PMC Advisers”); PMC Funding Corp. and its subsidiary (“PMC Funding”); and several special purpose entities (the “SPEs”) established to facilitate structured loan transactions. Our consolidated financial statements include the accounts of PMC Capital and its wholly-owned regulated investment company subsidiaries. The accounts of PMC Advisers and PMC Funding are accounted for using the equity method of accounting in conformity with the requirements of Federal securities laws. Our interests in the SPEs are accounted for as retained interests in transferred assets.

     In addition to our lending operations, we earn income through PMC Advisers which evaluates and services loans receivable and other investments pursuant to fee arrangements (the “Investment Management Agreements”) with PMC Commercial Trust (“PMC Commercial”), a real estate investment trust (“REIT”) affiliated with us through common management.

     PMC Commercial provides loans to entities whose borrowing needs and/or strength and stability exceed the limitations set by the SBA for our SBA approved loan programs. As a result, we generally pursue different prospective borrowers than PMC Commercial. In order to further mitigate the potential for conflicts of interest, PMC Capital, PMC Commercial and PMC Advisers have entered into a loan origination agreement (the “Loan Origination Agreement”). Pursuant to the Loan Origination Agreement, loans that are greater than $1.3 million that meet PMC Commercial’s underwriting criteria are first presented to PMC Commercial for funding. If PMC Commercial does not have available funds, we may originate those lending opportunities as long as they meet our lending criteria.

     As of December 31, 2002 and 2001, our total assets were approximately $140.3 million and $162.7 million, respectively. During the years ended December 31, 2002 and 2001, our total investment income was approximately $16.7 million and $20.8 million, respectively and our net increase in net assets resulting from operations (hereinafter referred to as “net income”) was approximately $6.0 million and $10.6 million, respectively.

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LENDING ACTIVITIES

– Overview

     The fair value of our loans receivable was $87.2 million and $107.4 million at December 31, 2002 and 2001, respectively. As of December 31, 2002, we have $71.3 million (82%) of variable-rate loans receivable and $15.9 million (18%) of fixed-rate loans receivable and the weighted average interest rate on our loans receivable was 7.1%.

     We primarily originate loans to small business concerns in the limited service sector of the hospitality industry. We have a fundamental policy with respect to loan concentration that requires us to have at least 25% of our total assets invested in the hospitality industry, and at December 31, 2002 our concentration was approximately 81%. We also emphasize lending to the convenience store and gas station, restaurant, service, retail and commercial real estate industries. We are a national lender that primarily lends to businesses in the southeast and southwest regions of the United States.

– Limited Service Hospitality Industry

     Our loans in the hospitality industry are generally collateralized by first liens on limited service hospitality properties and are generally made to owner-operated facilities operating under national franchises. We believe that franchise operations offer attractive lending opportunities because such businesses generally employ proven business concepts, have national reservation systems, have consistent product quality, are screened and monitored by franchisors and generally have a higher rate of success when compared to other independently operated hospitality businesses.

     Reductions in business and discretionary travel have caused a moderation in demand for hotel rooms and a slowdown in construction of hospitality properties (including limited service hospitality properties). However, the limited service segment of the hospitality industry has been less impacted and has continued to outperform the luxury and upscale sectors which experienced the weakest performance. Another factor which affects the limited service sector of the hospitality industry is a significant rise in gasoline prices within a short period of time. Most of the limited service hospitality properties collateralizing our loans receivable are located on interstate highways. As seen in the past, when gas prices sharply increase, occupancy rates for properties located on interstate highways decrease.

– Loan Originations and Underwriting

     We originate mortgage loans to small businesses primarily collateralized by commercial real estate. We believe that we successfully compete in the commercial real estate finance market due to our understanding of our borrowers’ businesses, the flexible loan terms that we offer and our responsive customer service. Our approach to assessing new commercial mortgage loans requires an analysis of the replacement cost of the collateral, its liquidation value and an analysis of local market conditions. We also consider the underlying cash flow of the tenant or owner-occupant as well as more traditional real estate loan underwriting criteria.

     Our variable-rate loans receivable require payments of principal and interest, reset on a quarterly basis, to amortize the principal over ten to 20 years. Our fixed interest rate loans receivable primarily require level payments of principal and interest calculated to amortize the principal over ten to 25 years.

     We have business development offices in Texas, Georgia, Arizona and Missouri and we solicit loan applications from potential borrowers through personal contacts and public appearances, direct mailings, advertisements in trade publications and other marketing vehicles. In addition, a significant percentage of new loans is generated through referrals from existing borrowers, lawyers, accountants, real estate brokers and loan brokers. In certain cases, we make referral payments to persons who assist in generating loan applications. Such referral payments generally are in amounts not exceeding 1% of the principal amount of the related loan. Our loan committee, comprised primarily of senior management, makes the final determination on whether or not to approve each loan application.

     Upon receipt of a completed loan application, our credit department conducts: (i) a detailed analysis of the loan, which typically includes an appraisal and a valuation by the credit department of the property that will

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collateralize the loan to assure compliance with loan-to-value percentages, (ii) a site inspection for real estate collateralized loans, (iii) a review of the borrower’s business experience, (iv) a review of the borrower’s credit history, and (v) an analysis of the borrower’s debt-service-coverage and debt-to-equity ratios. All appraisals must be performed by an approved licensed third party appraiser and based on the market value, replacement cost and cash flow value approaches. We generally utilize nationwide independent appraisal firms and seek local market economic information to the extent available.

     Our typical loan is distinguished from those of some of our competitors by the following characteristics:

	•		Substantial down payments are required. We usually require an initial down payment of not less than 20% of the value of the property which is collateral for the loan at the time of such loan. Our experience has shown that the likelihood of full repayment of a loan increases if the owner/operator is required to make an initial and substantial financial commitment to the property which is collateral for the loan.
	•		“Cash outs” are typically not permitted. Generally, we will not make a loan in an amount greater than either the cost or the current appraised value of the property which is collateral for the loan. For example, a hotel property may have been originally constructed for a cost of $2,000,000, with the owner/operator borrowing $1,600,000 of that amount. At the time of the borrower’s loan refinancing request, the property which is collateral for the loan is appraised at $4,000,000. Some of our competitors might loan from 70% to 90% or more of the new appraised value of the property and permit the owner/operator to receive a cash distribution from the proceeds. Generally, we would not permit this type of “cash-out” distribution.
	•		The obligor is personally liable for the loan. We generally require the principals of the borrower to guarantee the loan.

– Loan Activity

     The following table details our loan activity for the years indicated:

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– Quarterly Loan Originations

     The following table is a breakdown of loans originated on a quarterly basis during the years indicated:

– Loan Portfolio Statistics

     Information on our loans receivable, and combined with loans receivable which have been sold and which we service and have retained interests (the “Serviced Loan Portfolio”) was as follows, broken down by division:

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– Problem Loans

     Our policy with respect to loans receivable which are in arrears as to interest payments for a period in excess of 60 days is generally to discontinue the accrual of interest income and reverse previously recorded interest income which is deemed uncollectible. We will deliver a default notice and begin foreclosure and liquidation proceedings when we determine that pursuit of these remedies is the most appropriate course of action.

     Senior management closely monitors our problem loans which are classified into two categories: Impaired Loans and Special Mention Loans (together, “Problem Loans”). Our Impaired Loans are loans which are not complying with their contractual terms, the collection of the balance of the principal is considered impaired and on which its fair value is less than the remaining unamortized principal balance. Our Special Mention Loans are those loans receivable that are not complying with their contractual terms but we expect a full recovery of the principal balance through either collection efforts or liquidation of collateral.

     Information on our Problem Loans was as follows, broken down by division:

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– Industry Information on our Loan Portfolio

     The distribution of our loans receivable and our serviced loan portfolio by industry were as follows at December 31, 2002:

STRUCTURED LOAN TRANSACTIONS

– General

     Structured loan sale transactions are our primary method of obtaining funds for new loan originations. In a structured loan sale transaction, we contribute loans receivable to an SPE in exchange for an ownership interest in that entity. The SPE issues notes payable (usually through a private placement) to third parties and then distributes a portion of the notes payable proceeds to us. The notes payable are collateralized solely by the assets of the SPE which means that, should the SPE fail to make payments on the debt, the noteholders have no recourse to us. We have no obligation to pay the notes, nor do the holders of the notes have any recourse against our assets.

     We account for structured loan sale transactions as sales of our loans receivable and the SPE meets the definition of a qualifying SPE; as a result, neither the loans receivable contributed to the SPE nor the notes payable issued by the SPE are included in our consolidated financial statements. When a structured loan sale transaction is completed: (1) our ownership interests in the SPEs are accounted for as retained interests in transferred assets (the “Retained Interests”) and are recorded at the present value of our estimated future cash flows to be received from the SPE and (2) the difference between (i) the carrying value of the loans receivable sold and (ii) the sum of (a) cash received and (b) the initial value of the estimated future cash flows from the Retained Interests constitutes the gain or loss on sale. Gains or losses on these sales may represent a material portion of our net income in the period in which the transactions occur. These gains or losses also cause timing differences between our net income determined in accordance with generally accepted accounting principles and our investment company taxable income. See “Risk Factors — There May Be Significant Fluctuations in

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our Quarterly Results” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources-Dividends.”

     Since we rely on structured loan sale transactions as our primary source of operating capital to fund new loan originations, any adverse changes in our ability to complete this type of transaction, including any negative impact on the asset-backed securities market for the type of product we generate, could have a detrimental effect on our ability to generate funds to originate loans.

     Problems in the asset-backed securities market that could affect our ability to complete a structured loan transaction on a timely basis or cause us to sell our loans receivable on less favorable terms include, but are not limited to, the following:

	•		As a result of certain economic conditions, investors in the type of asset-backed securities that we place may widen the “spreads” they require in order to purchase asset-backed securities;
	•		Deterioration in the performance of either our loans receivable or the loans receivable of PMC Commercial may deter potential investors from purchasing our asset-backed securities;
	•		Deterioration in the operations of the limited service sector of the hospitality industry which may deter potential investors from purchasing our asset-backed securities or lower the available rating from the rating agencies;
	•		A reduction in the performance of the loans receivable of our prior transactions or of similar transactions (for example, higher than expected loan losses or delinquencies) may deter potential investors from purchasing our asset-backed securities; and
	•		A change in the underlying criteria utilized by the rating agencies may cause transactions to receive lower ratings than previously issued thereby increasing the cost of capital and decreasing the “spread” on our transaction.

     Significant changes in any of these criteria may result in us temporarily suspending our structured loan sale program and we may seek other sources of financing. See “Risk Factors — The Market for Structured Loan Sale Transactions May Change.”

     Our Retained Interests consist of (i) the retention of a portion of each of the sold loans (the “required overcollateralization”), (ii) required cash balances owned by the SPE (the “reserve fund”) and (iii) future excess funds to be generated by the SPE after payment of all obligations of the SPE (the “interest-only strip receivable”). The value of our Retained Interests is determined based on the present value of estimated future cash flows that we will receive from the SPEs. The estimated future cash flows are calculated based on assumptions concerning, among other things, loan losses and prepayment speeds. On a quarterly basis, we measure the fair value of, and record income relating to, the Retained Interests based upon the future anticipated cash flows discounted based on an estimate of market interest rates for investments of this type. Any appreciation (depreciation) of our Retained Interests is included in the accompanying statement of operations as either a realized loss (if there is a reduction in expected future cash flows) or unrealized gain (loss) on investments.

     We retain a portion of the default and prepayment risk associated with the underlying transferred loans receivable of our Retained Interests. Actual defaults and prepayments with respect to estimating future cash flows for purposes of valuing the Retained Interests will vary from assumptions, possibly to a material degree, and slower (faster) than anticipated prepayments of principal or lower (higher) than anticipated loan losses will increase (decrease) the fair value of our Retained Interests and the related cash flows. See “Risk Factors — There is Volatility in the Valuation of Our Retained Interests.” We regularly measure our loan loss, prepayment and other assumptions against the actual performance of the loans receivable sold. Although we believe that reasonable assumptions as to the future cash flows have been made, actual rates of loss or prepayments will vary from those assumed and these assumptions may be revised based upon changes in facts or circumstances.

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     In connection with our structured loan sale transactions, limited partnerships and joint ventures have been formed as SPEs to hold the loans receivable sold and issue certificates or notes payable collateralized by the loans receivable. As of December 31, 2002, our SPEs consisted of:

	•		FW 97 L.L.C. (“First Western 1997”);
	•		PMC Capital, L.P. 1998-1 (the “1998 Partnership”) and its related general partner;
	•		PMC Capital, L.P. 1999-1 (the “1999 Partnership”) and its related general partner;
	•		PMC Joint Venture, L.P. 2000 (the “2000 Joint Venture”) and its related general partner;
	•		PMC Joint Venture, L.P. 2001 (the “2001 Joint Venture”) and its related general partner; and
	•		PMC Joint Venture, L.P. 2002-1 (the “2002 Joint Venture,” and together with the 2000 Joint Venture and the 2001 Joint Venture, the “Joint Ventures”) and its related general partner.

     PMC Capital owns 100% of First Western 1997, the 1998 Partnership and the 1999 Partnership. In addition, PMC Capital owned approximately 34% of the 2000 Joint Venture, 61% of the 2001 Joint Venture and 61% of the 2002 Joint Venture as of December 31, 2002. The balance of the Joint Ventures is owned by PMC Commercial. Our share of the cash flows from the Joint Ventures is allocated based on the cash flows from the underlying loans receivable contributed by us to the respective Joint Venture less allocated costs based on the remaining principal on the underlying loans receivable contributed by us divided by all loans receivable held by the respective Joint Venture.

     Information relating to our structured loan sale transactions is as follows:

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     In addition to the transactions described above, the SBA guaranteed portion of First Western’s loans receivable are sold to either dealers in government guaranteed loans receivable or institutional investors (“Secondary Market”) as the loans are funded. On all Secondary Market transactions, we retain an excess spread between the interest rate paid to us from our borrowers and the rate we pay to the purchaser of the guaranteed portion of the note.

– Structured Loan Sale Transaction Completed During 2002

     On April 12, 2002, we completed a structured loan sale transaction of a pool of primarily fixed-rate loans receivable. PMC Capital and PMC Commercial contributed loans receivable of $43.2 million and $27.3 million, respectively, to the 2002 Joint Venture. The 2002 Joint Venture issued, through a private placement, approximately $63.5 million of its 2002 Loan-Backed Fixed Rate Notes (the “2002 L.P. Notes”) of which approximately $38.9 million (the “2002 PMC L.P. Notes”) was allocated to us based on our ownership percentage in the 2002 Joint Venture. The 2002 L.P. Notes, issued at par, have a stated maturity in 2023, bear interest at 6.67% and are collateralized by the loans receivable contributed by us and PMC Commercial to the 2002 Joint Venture. We accounted for this transaction as a sale, recorded a gain of $1,463,000 and recorded our Retained Interests at an initial amount of $8,772,000 during 2002.

     The net proceeds from the issuance of the 2002 PMC L.P. Notes (approximately $37.9 million) were distributed to us. These proceeds were net of our issuance costs and prior to funding the required reserve balance. At inception of the 2002 Joint Venture and at December 31, 2002, we owned a 61% limited partnership interest based on our share of the capital.

– Structured Loan Sale Transaction Completed During 2001

     On June 27, 2001, we completed a structured loan sale transaction of a pool of fixed-rate loans receivable. PMC Capital and PMC Commercial contributed loans receivable of $49.2 million and $32.7 million, respectively, to the 2001 Joint Venture. The 2001 Joint Venture issued, through a private placement, approximately $75.4 million of its 2001 Loan-Backed Fixed Rate Notes (the “2001 L.P. Notes”) of which approximately $45.2 million (the “2001 PMC L.P. Notes”) was allocated to us based on our ownership percentage in the 2001 Joint Venture. The 2001 L.P. Notes, issued at par, have a stated maturity in 2021, bear interest at 6.36% and are collateralized by the loans receivable contributed by us and PMC Commercial to the 2001 Joint Venture. We accounted for this transaction as a sale, recorded a gain of $2,732,000 and recorded our Retained Interests at an initial amount of $9,186,000 during 2001.

     The net proceeds from the issuance of the 2001 PMC L.P. Notes (approximately $44.5 million) were distributed to us. These proceeds are net of our issuance costs and prior to funding the required reserve balance. At inception of the 2001 Joint Venture, we owned a 60% limited partnership interest based on our share of the capital. At December 31, 2002, we owned a 61% limited partnership interest in the 2001 Joint Venture.

– Structured Loan Sale Transaction Completed During 2000

     On December 18, 2000, we completed a structured loan sale transaction of a pool of fixed-rate loans receivable. PMC Capital and PMC Commercial contributed loans receivable of $28.0 million and $55.7 million, respectively, to the 2000 Joint Venture. The 2000 Joint Venture issued, through a private placement, approximately $74.5 million of its 2000 Loan-Backed Fixed Rate Notes (the “2000 L.P. Notes”) of which approximately $25.0 million (the “2000 PMC L.P. Notes”) was allocated to us based on our ownership percentage in the 2000 Joint Venture. The 2000 L.P. Notes, issued at par, have a stated maturity in 2024, bear interest at 7.28% and are collateralized by the loans receivable contributed by us and PMC Commercial to the 2000 Joint Venture. We accounted for this transaction as a sale, recorded a gain of $564,000 and recorded our Retained Interests at an initial amount of $5,573,000 during 2000.

     The net proceeds from the issuance of the 2000 PMC L.P. Notes (approximately $24.7 million) were distributed to us. These proceeds are net of our issuance costs and prior to funding the required reserve balance. At inception of the 2000 Joint Venture and at December 31, 2002, we owned a 34% limited partnership interest based on our share of the capital.

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– Joint Structured Loan Sale Transactions – General

     The terms of the 2002 L.P. Notes, the 2001 L.P. Notes and the 2000 L.P. Notes (the “JV Notes”) provide that each of the partners of the respective Joint Ventures is not liable for any payments on the JV Notes. Accordingly, if the Joint Ventures fail to pay the JV Notes, the sole recourse of the holders of the JV Notes is against the assets of the respective Joint Venture. Accordingly, we have no obligation to pay the JV Notes, nor do the holders of the JV Notes have any recourse against our assets.

     PMC Capital and PMC Commercial have entered into cross indemnification agreements regarding the performance of their respective loans receivable sold to the Joint Ventures. To the extent that poor performance by either PMC Commercial’s or PMC Capital’s sold loans receivable (the “Underperforming Company”) is pervasive enough to cause the other company (the “Performing Company”) to not receive cash flow that it otherwise would have received, then the Underperforming Company must make the Performing Company whole. If the cash flow reduction is considered to be temporary, then interest will be paid as compensation to the Performing Company. In general, when a loan is liquidated, it may cause a deferral of cash flow to the Performing Company and, as a result, interest would be charged to the Underperforming Company until the cash flow from the Joint Venture repays the Performing Company. If the reduction of cash flows is deemed permanent (i.e., to the extent that the Underperforming Company will not be able to satisfy the shortfall with the assets they have contributed to the related structured loan sale transaction), the balance of reduction to cash flows must be paid to the Performing Company by the Underperforming Company. At December 31, 2002, the maximum potential amount of future payments to PMC Commercial (undiscounted and without consideration of any recoveries from the underlying loans receivable) we could be required to make under these cross indemnification agreements was approximately $34.3 million and the discounted amount was $23.5 million which represents the estimated fair value of the Retained Interests reflected on PMC Commercial’s consolidated balance sheet for the Joint Ventures. All of our loans are collateralized; however, the maximum potential amount of future payments we could be required to make under these cross indemnification agreements has not considered any proceeds from the liquidation of collateral underlying these loans. Upon completion of a joint securitization and on each subsequent quarterly reporting date, management evaluates the need to recognize a liability associated with the indemnification agreements. Based on present cash flow assumptions, including stress test analyses of increasing the anticipated losses on each of the loan pools, it does not appear that the loans receivable sold by us will cause any permanent cash flow reductions to PMC Commercial nor does it appear that the loans receivable sold by PMC Commercial will cause any permanent cash flow reduction to us. Accordingly, we believe that the fair value of these cross indemnification agreements at inception of the Joint Ventures and as of December 31, 2002 and 2001 was zero; thus, no liability was recorded. If the performance of our sold loans receivable significantly deteriorates, it could be necessary for us to perform under these cross indemnification agreements.

     When our structured loan sale transactions were completed, the transaction documents that the SPE entered into contained provisions (the “Credit Enhancement Provisions”) that govern the assets and the flow of funds in and out of the SPE formed as part of the structured loan sale transactions. The Credit Enhancement Provisions include specified limits on the delinquency, default and loss rates on loans receivable included in each SPE. If, at any measurement date, the delinquency, default or loss rate with respect to any SPE were to exceed the specified limits, the Credit Enhancement Provisions would automatically increase the level of credit enhancement requirements for that SPE. During the period in which the specified delinquency, default or loss rate was exceeded, excess cash flow from the SPE, if any, would be used to fund the increased credit enhancement levels instead of being distributed, which would delay or reduce our distribution.

ADVISORY SERVICES

     As the investment advisor for PMC Commercial, PMC Advisers has earned $2.3 million, $2.3 million and $2.2 million in advisory fees during the years ended December 31, 2002, 2001 and 2000, respectively. The fees of PMC Advisers (pursuant to the Investment Management Agreements) are primarily based on the value of PMC Commercial’s assets. As a result, any increases in the dollar amount of PMC Commercial’s assets will benefit PMC Advisers, and PMC Advisers may have a potential conflict in determining whether to advise PMC Commercial to acquire assets or write-down the value of any assets. In order to mitigate the risk to PMC Commercial from increasing its asset base through leveraged transactions, the Investment Management Agreements provide PMC Advisers with a reduced fee for any loans originated with capital obtained through borrowings. The Investment Management Agreements are renewable on an annual basis.

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     Pursuant to the Investment Management Agreements entered into between PMC Commercial and PMC Advisers, fees of between 0.40% and 1.55%, annually, are charged by PMC Advisers based upon the average principal outstanding of PMC Commercial’s loans. In addition, the Investment Management Agreements include compensation to PMC Advisers for its assistance in the issuance of PMC Commercial’s debt and equity securities and the acquisition by PMC Commercial of limited service hospitality properties. The Investment Management Agreements also provide for (i) an annual fee of 0.70% of the original cost of the hospitality properties to be paid to PMC Advisers relating to leases entered into by PMC Commercial, (ii) a fee of $10,000 upon the sale of each limited service hospitality property and (iii) an annual loan origination fee equal to five basis points of loans funded for the first $20 million in loans and 2.5 basis points thereafter.

REGULATORY OVERVIEW

– Investment Company Act Regulations

     PMC Capital is in compliance with the requirement to maintain a minimum of 200% asset coverage of debt as defined in sections 18 and 61 of the 1940 Act as modified by exemptive orders obtained by us from the Securities and Exchange Commission (the “SEC”).

     We may not sell shares of common stock below net asset value unless we obtain approval from a “majority of the outstanding voting” securities as defined in the 1940 Act. We may sell shares of common stock in a rights offering at a price below our net asset value without shareholder approval under the 1940 Act.

     We may be prohibited under the 1940 Act from knowingly participating in certain transactions with our affiliates without the prior approval of our Board of Directors (“Board”) who are not interested persons and, in some cases, prior approval by the SEC. We have been granted an exemptive order by the SEC permitting us to engage in certain transactions that would be permitted if we and our subsidiaries were one company and permitting certain transactions among our subsidiaries, subject to certain conditions and limitations. One of our exemptive orders permits PMC Capital to establish SPEs owned by PMC Capital and PMC Commercial to engage in joint securitizations.

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

     We maintain a code of ethics that establishes procedures for personal investment and restricts certain transactions by our personnel. Our code of ethics does not permit investment by our employees in securities that may be purchased or held by us.

– Business Development Company (“BDC”) Regulations

     PMC Capital has elected to be regulated as a BDC. BDCs must have a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and are subject to the Exchange Act’s periodic reporting requirements rather than the 1940 Act’s reporting requirements. BDCs have greater operating flexibility than other investment companies relating to capital structure, portfolio diversification, transactions with downstream affiliates, executive stock options and the frequency which they may make distributions from capital gains. A BDC’s focus is on investing in or lending to small private companies and making managerial assistance available to them. A BDC may use capital provided by public shareholders and from other sources to invest in long-term, private investments in growing small businesses. A BDC provides shareholders the ability to retain the liquidity of a publicly traded stock, while sharing in the benefits, if any, of investing in privately owned companies. As a BDC, we may not acquire any asset other than “Qualifying Assets” unless, at the time we make the acquisition, our Qualifying Assets represent at least 70% of the value of our total assets (the “70% test”). The principal categories of Qualifying Assets relevant to our business are:

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(1)  Securities purchased in transactions not involving any public offering, the issuer of which is an eligible portfolio company. An eligible portfolio company is defined to include any issuer that:

	a.		is organized and has its principal place of business in the United States,
	b.		is not an investment company other than an SBIC wholly-owned by a BDC (our investments in PMCIC and Western Financial are Qualifying Assets), and
	c.		does not have any class of publicly traded securities with respect to which a broker may extend margin credit;

(2)  Securities received in exchange for or distributed with respect to securities described in (1) above or pursuant to the exercise of options, warrants, or rights relating to such securities; and

(3)  Cash, cash items, government securities, or high quality debt securities (within the meaning of the 1940 Act), maturing in one year or less from the time of investment.

     To include certain securities described above as Qualifying Assets for the purpose of the 70% test, a BDC must make available to the issuer of those securities significant managerial assistance such as providing guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company, or making loans to a portfolio company. We will provide managerial assistance on a continuing basis to any portfolio company upon request.

     As a BDC, we are entitled to issue senior securities in the form of stock or senior securities representing indebtedness, as long as each class of senior security has an asset coverage of at least 200% immediately after each such issuance. This limitation is not applicable to borrowings by our SBIC or SBLC subsidiaries, and therefore any borrowings by these subsidiaries are not included in this asset coverage test. We may not change the nature of our business so as to cease to be, or withdraw our election as, a BDC unless authorized by vote of a “majority of the outstanding voting securities,” as defined in the 1940 Act. A majority of the outstanding voting securities of a company is defined under the 1940 Act as the lesser of (i) 67% or more of such company’s shares present at a meeting if more than 50% of the outstanding shares of such company are present and represented by proxy, or (ii) more than 50% of the outstanding shares of such company.

– Regulated Investment Company (“RIC”) Regulations

     Our status as a RIC enables us to avoid the cost of Federal and state income taxation and, as a result, achieve pre-tax investment returns. We believe that this tax advantage enables us to achieve strong equity returns without having to aggressively leverage our balance sheet. In order to qualify as a RIC, we must, among other things:

(1)  Derive at least 90% of our gross income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities or other income derived with respect to our business of investing in such stock or securities;

(2)  Diversify our holdings so that:

	a.		at least 50% of the value of our assets consists of cash, cash items, government securities, securities of other RICs and other securities if such other securities of any one issuer do not represent more than 5% of our assets and 10% of the outstanding voting securities of the issuer; and
	b.		no more than 25% of the value of our assets are invested in securities of one issuer (other than U.S. government securities or securities of other RICs), or of two or more issuers that are controlled by the Company; and

(3)  Distribute at least 90% of our “investment company taxable income” each tax year to the shareholders. In addition, if a RIC distributes in a timely manner (or treats as “deemed distributed”) 98% of its capital gain net income for each one-year period ending on October 31 and distributes 98% of its ordinary income for each calendar year, it will not be subject to the 4% nondeductible Federal excise tax on certain undistributed income of RICs.

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– Fundamental and Other Policies of PMC and its Subsidiaries

     We have established a core set of fundamental policies. PMC Capital and each of its investment company subsidiaries have designated certain investment policies as “fundamental policies.”

     The following investment policies of PMC Capital and its investment company subsidiaries are fundamental policies and may not be changed without the approval of the lesser of (i) more than 50% of PMC Capital’s outstanding voting securities, or (ii) 67% or more of PMC Capital’s voting securities present at a meeting of security holders at which a quorum is present. Our Board may change any other investment policies of PMC Capital at any time.

1)		The Company will not purchase or sell commodities or commodity contracts.
2)		The Company will not engage in short sales, purchase securities on margin or trade in contracts commonly called puts or calls or in combinations thereof, except that it may acquire warrants, options or other rights to subscribe to or sell securities in furtherance of its investment objectives.
3)		The Company will not underwrite securities of other issuers, except that it may acquire portfolio securities under circumstances where, if sold, the Company might be deemed an underwriter for purposes of the Securities Act of 1933. The Company may purchase “restricted securities” as to which there are substantial restrictions on resale under the Securities Act of 1933.
4)		The Company will not purchase any securities of a company if any of the directors or officers of the Company owns more than 0.5% of such company and such persons owning more than 0.5% together own 5% or more of the shares of such company.
5)		The Company may issue senior securities in the form of debentures, reverse repurchase agreements and preferred stock and may borrow monies from banks and other lenders, all on an unsecured basis. The 1940 Act limits the Company to the issuance of one class of senior debt securities and one class of senior equity securities (as such terms are defined in the 1940 Act).
6)		The Company will not invest more than 25% of its total assets in any one industry except in the lodging industry which may constitute 100% of the Company’s portfolio. The Company will invest at least 25% of its total assets in the lodging industry.
7)		The Company may invest in real estate development companies, may make real estate acquisition loans and real estate improvement loans and may further make other loans secured by real estate.
8)		The Company may make loans and purchase debt securities in furtherance of its investment objectives. The Company will not make loans to its officers, directors or other affiliated persons.
9)		PMCIC will perform the functions and conduct the activities contemplated under the SBIA, and will provide assistance solely to small business concerns which will contribute to a well-balanced national economy by facilitating ownership of such concerns by persons whose participation in the free enterprise system is hampered because of social or economic disadvantages. These fundamental policies of PMCIC may not be changed without the prior written consent of the SBA.

– SBA Regulations

     The lending operations of First Western, PMCIC and Western Financial are regulated by the SBA, which establishes, among other things, maximum interest rates that borrowers may be charged and minimum and maximum maturities for our loans receivable (which generally range from seven to 25 years). The maximum interest rates which PMCIC and Western Financial can charge may not exceed the greater of 19% per annum or 11% above our cost of funds from the SBA and was 19% at December 31, 2002. Borrowers must satisfy certain criteria established by the SBA to qualify for loans originated by us under SBA sponsored programs, including limitations on the net worth and net income of potential borrowers or alternative criteria that focus upon the number of employees of the borrower and its gross revenues. In addition, the SBA generally limits the aggregate amount of guaranties that can be provided to any single borrower and restricts the use to which the

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loan proceeds can be employed by the borrower. Effective October 1, 2002, the SBA temporarily changed its policy on origination of loans under the SBA 7(a) Guaranteed Loan Program to limit the maximum amount of a loan to $500,000 (the “Loan Cap”). As a result of legislation that Congress passed, in February 2003 the SBA discontinued the Loan Cap.

     SBICs are intended to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the most recent two fiscal years. In addition, an SBIC must devote 20% of its investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the most recent two fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses, and provide them with consulting and advisory services.

     Both Western Financial and PMCIC provide long-term loans to qualifying small businesses. Western Financial and PMCIC have the opportunity to borrow up to an additional aggregate principal amount of $37.2 million of SBA debentures, based on their regulatory capital. Under SBA regulations, an SBIC may borrow up to $111.7 million from the SBA as governed by SBA regulations. This limit generally applies to all financial assistance provided by the SBA to an SBIC licensee and its “associates,” as the term is defined by SBA regulations. Western Financial and PMCIC had outstanding $14.3 million of SBA debentures and PMCIC had $7.0 million of preferred stock investments from the SBA at December 31, 2002. At December 31, 2002, we had an outstanding commitment from the SBA to purchase up to $5.2 million ($4.2 million expiring September 2003 and $1.0 million expiring September 2004) in additional SBA debentures. As leveraged SBIC’s, PMCIC and Western Financial are subject to certain regulatory restrictions such as change in control provisions.

     First Western is licensed to operate as an SBLC. The SBA guarantees 75% of qualified loans over $150,000 with such individual guarantees not exceeding $1.0 million. While the eligibility requirements of the SBA 7(a) Program vary by the industry of the borrower and other factors, the general eligibility requirements are that: (i) gross sales of the borrower cannot presently exceed $6 million, (ii) liquid assets or real estate equity of the borrower and affiliates cannot exceed specified limits, and (iii) the maximum aggregate SBA loan guarantees to a borrower cannot exceed $1.0 million. Maximum maturities for SBA 7(a) loans are 25 years for real estate and 15 years for the purchase of machinery and equipment. In order to operate as an SBLC, a licensee is required to maintain a minimum net worth (as defined by SBA regulations) of the greater of (i) 10% of the outstanding loans receivable of First Western or (ii) $1.0 million, as well as certain other regulatory restrictions such as change in control provisions.

     First Western, PMCIC and Western Financial are periodically examined and audited by the SBA to determine compliance with SBA regulations.

RISK FACTORS

     Management has identified the following important factors that could cause actual results to differ materially from those reflected in forward-looking statements or from our historical results. These factors, while not all-inclusive, could have a material impact on our asset valuations, results of operations or financial condition. In addition, these factors could impair our ability to maintain dividend distributions at current levels.

– Our Investments Are Valued at Fair Value

     Pursuant to the requirements of the 1940 Act, we value our investments at fair value on a quarterly basis as determined in good faith by our Board. Since there is typically no readily ascertainable market value for the investments in our portfolio, our Board determines 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. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment while employing a

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consistently applied valuation process for the types of investments we make. Unlike banks, we are not permitted to provide a general reserve for anticipated losses. We are instead required by the 1940 Act to specifically value each individual investment and record unrealized depreciation for an investment that we believe has become impaired or where collection of a loan is in doubt. Conversely, we will record unrealized appreciation if we have an indication that the underlying assets in the portfolio have appreciated in value and therefore, our security has also appreciated in value, as appropriate. Due to the inherent uncertainty of valuation, fair value of our investments determined in good faith by the Board may differ from the values that would have been used had a ready market existed for the investments and the differences could be material.

– There is Volatility in the Valuation of Our Retained Interests

     Due to the limited number of entities that conduct transactions with similar assets, the relatively small size of our Retained Interests and the limited number of buyers for such assets, no readily ascertainable market exists for our Retained Interests. Therefore, the Board’s determination of the fair value may vary significantly from the value had a readily ascertainable market existed. If we were forced to immediately liquidate some or all of our Retained Interests, the proceeds of such liquidation may be significantly less than the current value of such Retained Interests.

     The value of our Retained Interests is determined based on assumptions concerning, among other things, anticipated defaults, discount rates and prepayment speeds. We retain a portion of the default and prepayment risk associated with the underlying loans receivable of our Retained Interests. As more fully described below, actual defaults and prepayments with respect to estimating future cash flows for purposes of valuing the Retained Interests may vary from assumptions, possibly to a material degree, and slower (faster) than anticipated prepayments of principal or lower (higher) than anticipated loan losses will increase (decrease) the fair value of our Retained Interests and the related estimated cash flows. The discount rates that we utilize are determined for each of the assets comprising the Retained Interests based upon an estimate of the inherent risks associated with each asset.

     The following is a sensitivity analysis of our Retained Interests as of December 31, 2002 to highlight the volatility that results when prepayments, loan losses and discount rates are different than our assumptions:

     These sensitivities are hypothetical and should be used with caution. Pro-forma values based on changes in these assumptions generally cannot be extrapolated since the relationship of the change in assumption to the change in fair value may not be linear. The effect of a variation in a particular assumption on the fair value of our Retained Interests is calculated without changing any other assumption. In reality, changes in one factor are not isolated from changes in another which might magnify or counteract the sensitivities.

     Changes in any of these assumptions, or actual results which deviate from the assumptions, affect the value of our Retained Interests, possibly to a material degree. There can be no assurance as to the accuracy of these estimates.

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– We Have a Concentration of Investments in the Hospitality Industry and Texas

     We have a fundamental policy regarding investment in the hospitality industry. At December 31, 2002, our investment in loans to businesses in the hospitality industry comprised approximately 81% and 85% of our total assets and loans receivable, respectively. Any economic factors that negatively impact this industry could have a material adverse effect on our financial condition and results of operations.

     At December 31, 2002, loans receivable to businesses located in Texas comprised approximately 29% of our loans receivable. No other state had a concentration of 10% or greater of our loans receivable at December 31, 2002. In addition, approximately 27% of the loans receivable underlying our Retained Interests are also concentrated in Texas. A decline in economic conditions in Texas could have a material adverse effect on our financial condition and results of operations.

– The Market for Structured Loan Sale Transactions May Change

     We will continue to need capital to fund loans. Our ability to continue to grow depends, to a large extent, on our ability to complete structured loan sale transactions. In certain economic markets, the availability of funds may be diminished or the “spread” charged for funds may increase causing us to delay a structured loan sale transaction. Terrorist attacks, bankruptcies or other political events, including the impact of war, could impact the availability and cost of our capital.

     It is anticipated that our working capital needs for 2003 will require us to complete a variable-rate structured loan sale transaction with PMC Commercial during the first half of 2003. Due to the current economic and interest rate environments, we may experience difficulties in selling our variable-rate loans receivable at an acceptable “spread.” Certain economic conditions may cause investors in the type of asset-backed securities that we place to widen the “spreads” they require in order to purchase asset-backed securities.

     A reduction in the availability of this source of funds could have a material adverse effect on our financial condition and results of operations since working capital may not be available to fund our current commitments or future loan originations.

– We Are Subject to Prepayment Risk

     Prepayments generally increase during times of declining interest rates. The proceeds from the prepayments we receive are invested initially in temporary investments and have generally been re-loaned or committed to be re-loaned at lower interest rates than the prepaid loans receivable. The lower interest rates we receive on these new loans receivable have had an adverse effect on our results of operations and depending upon the rate of future prepayments may further impact our results of operations. The impact of the lower lending rates on our net investment income may be partially offset by the reduced cost of our variable-rate borrowings in a lower interest rate environment. In addition, when loans receivable (other than SBA 7(a) Program loans originated prior to January 1, 2001) are repaid prior to their maturity, we generally receive prepayment fees which result in one-time increases in our other income.

     Prepayments may also affect our “spread” on the pool of loans sold in our structured loan sale transactions. Prepayments of loans receivable with higher interest rates negatively impact the value of our Retained Interests to a greater extent than prepayments of loans receivable with lower interest rates. Prepayments in excess of assumptions will cause a decline in the value of our Retained Interests primarily relating to the excess funds (our interest-only strip receivable) expected from our structured loan sale transactions. For example, if a $1.0 million loan with an interest rate of 10% prepays and the “all-in cost” of that Joint Venture’s structured notes was 7%, we would lose the 3% spread we had expected to receive on that loan in future periods. Our “all-in costs” include interest, servicing, trustee and other ongoing costs. The “spread’ that is lost may be offset in part or in whole by the prepayment fee that we collect.

     First Western sells the guaranteed portion of most of its originated loans through private placements. These sales are included in our Retained Interests and are especially sensitive to prepayments. Our Retained Interest in these loan sales consists only of the spread between the interest we collect from the borrower and the interest we pay the purchaser of the guaranteed portion of the loan. Therefore, to the extent the prepayments of these

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loans exceed estimates, there is a significant impact on the value of the associated Retained Interests. See — “There is Volatility in the Valuation of our Retained Interests.”

– We Are Subject to Interest Rate Risk

     Our net interest margin is affected by changes in the spread between the rate at which we borrow funds and the rate at which we loan these funds. PMC Capital, Western Financial and PMCIC currently originate primarily variable interest rate loans and the borrowed funds of these companies are typically long-term and at fixed interest rates. First Western originates variable interest rate loans and has utilized both advances from PMC Capital and the sale of its loans receivable to obtain funds necessary to originate loans. If the yield on loans originated by us with funds obtained from borrowings or preferred stock fails to cover the cost of such funds, our cash flow will be reduced. During periods of changing interest rates, interest rate mismatches on our loans receivable could negatively impact our net investment income, dividend yield and the market price of our common stock.

     As a result of our dependence on variable-rate loans (we are currently originating primarily variable-rate loans and all of our current commitments are for variable-rate loans), our interest income has been, and will continue to be, reduced. In addition, to the extent that rates remain at these historically low levels, or LIBOR or the prime rate decreases from current levels, interest income on our currently outstanding loans receivable will decline.

     Changes in interest rates do not have an immediate impact on interest income with regard to fixed-rate loans receivable. Our interest rate risk on our fixed-rate loans receivable is primarily due to loan prepayments and pay-offs. The average maturity of our loans receivable is less than their average contractual terms because of prepayments. The average life of mortgage loans tends to increase when the current mortgage loan rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when the current mortgage loan rates are substantially lower than rates on existing mortgage loans (due to refinancings of fixed-rate loans).

– There is Volatility in the Valuation of our Loans Receivable and Assets Acquired in Liquidation

     The valuation of our loans receivable and assets acquired in liquidation are determined in good faith by our Board. There is typically no public market or established trading market for the loans we originate. The illiquid nature of our loans receivable and assets acquired in liquidation may adversely affect our ability to dispose of these investments at times when it may be advantageous for us to liquidate them. The valuation of our loans receivable and assets acquired in liquidation is adjusted on a quarterly basis to reflect the good faith determination of our Board as to their current fair value. The determination of fair value requires judgment and consideration of the facts and circumstances existing at the evaluation date. Adverse changes to the facts and circumstances of the collateral, borrower, industry and/or the economy will impact the Board’s determination of value and may require valuation losses which may be material to our results of operations. In the absence of a readily ascertainable market, the value of the loans receivable may differ from the values that would be placed if a ready market existed. If we were forced to immediately liquidate some or all of our loans receivable, the proceeds of such liquidation may be significantly less than the current value of such loans receivable.

     Losses on our loans (realized and unrealized) were 0.56% (56 basis points) of our weighted average outstanding loans receivable during the year ended December 31, 2002. To the extent we are forced to liquidate one or several of our loans, future losses may be substantial. The change in assets and net income if the valuation of our loan portfolio were to decline is as follows:

– We Are Subject to Government Regulations Affecting our Assets Acquired in Liquidation

     In conjunction with our assets acquired in liquidation, we are subject to numerous Federal, state and local laws and government regulations including environmental, occupational health and safety, state and local taxes and laws relating to access for disabled persons.

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     Under various Federal, state and local laws, ordinances and regulations, a current or former owner or operator of real estate may be considered liable for the costs of remediating or removing hazardous substances found on its property, regardless of whether or not the property owner or operator was responsible for its presence. Such liability may be imposed regardless of fault and may be joint and several. We have not been informed by the Environmental Protection Agency or any state or local government authority of any non-compliance likely to be material to our financial condition or results of operations.

     We are also subject to the Americans with Disabilities Act of 1990 (“ADA”), which requires all public accommodations and commercial facilities to meet federal requirements related to access and use by disabled persons. Compliance with ADA requirements could require removal of access barriers, and noncompliance could result in imposition of fines by the United States government or an award of damages to private litigants. Although we believe that the properties we own are substantially in compliance with these requirements, a determination that the properties are not in compliance with the ADA could result in the imposition of fines or an award of damages to private litigants.

– We Are Leveraged

     We have borrowed funds and issued shares of preferred stock and intend to borrow additional funds through advances on our revolving credit facility and discretionary guidance line and through the issuance of notes payable or SBA debentures, if available. As a result, we use leverage to fund our capital needs. The SBA and private lenders have fixed dollar claims on our assets superior to the claims of the holders of our common stock. Leverage magnifies the effect that rising or falling interest rates have on our earnings. Any increase in the interest rate earned by us on investments in excess of the interest rate or dividend payable on the funds obtained from either borrowings or the issuance of preferred stock would cause our net income and earnings per share to increase more than it would without leverage, while any decrease in the interest rate earned by us on investments would cause net income and earnings per share to decline by a greater amount than it would without leverage. Leverage is thus generally considered a speculative investment technique. In order for us to repay indebtedness or meet our obligations in respect of any outstanding preferred stock on a timely basis, we may be required to dispose of assets when we would not otherwise do so and at prices which may be below the net book value of such assets. Dispositions of assets could have a material adverse effect on our financial condition and results of operations.

– The Economic and Competitive Environments May Change

     Our primary competition has come from banks, financial institutions and other finance companies. Many of these competitors have greater financial and larger managerial resources than us and are able to provide services that we are not able to provide (i.e., depository services). In general, we believe we compete effectively with such entities on the basis of the variety of our lending programs offered, interest rates, our long-term maturities and payment schedules, the quality of our service, our reputation as a lender, timely credit analysis and decision-making processes, and the renewal and refinancing options available to borrowers. In addition, the variety and flexibility of our lending programs enhances our ability to react to current market conditions.

     Several factors may impact the ability of our borrowers to meet their contractual payment obligations. During economic downturns, there may be reductions in business travel and consumers generally take fewer vacations. Another factor which affects the limited service sector of the hospitality industry is a significant rise in gasoline prices within a short period of time. Most of the limited service hospitality properties collateralizing our loans receivable are located on interstate highways. As seen in the past, when gas prices sharply increase, occupancy rates for properties located on interstate highways decrease. These factors may cause a reduction in revenue per available room (“RevPar”). If RevPar for the limited service sector of the hospitality industry were to experience significant sustained reductions, the ability of our borrowers to meet their obligations could be impaired and losses could increase.

     Economic recessions or downturns could impair our borrowers and harm our operating results. Many of the companies in which we have made or will make loans may be susceptible to economic slowdowns or recessions. Terrorism, bankruptcies or other political events, including the impact of war, could affect our borrowers. Our substandard assets are likely to increase and the value of our portfolio is likely to decrease

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during these periods. These conditions could lead to losses in our portfolio and a decrease in our net investment income, net income and assets.

– There Are Significant Risks in Lending to Small Businesses

     Our loans receivable consist primarily of loans to small, privately-owned companies. There is no publicly available information about these companies; therefore, we rely on the due diligence of our employees to obtain information in connection with our investment decisions. Our borrowers may not meet net income, cash flow and other coverage tests typically imposed by bank lenders. A borrower’s ability to repay its loan may be adversely impacted by numerous factors, including a downturn in its industry or negative economic conditions. Deterioration in a borrower’s financial condition and prospects may be accompanied by a deterioration in the collateral for the loan receivable. In addition, small businesses depend on the management talents and efforts of one person or a small group of people for their success. The loss of services of one or more of these persons could have a material adverse impact on the operations of the small business. Small companies are typically more vulnerable to customer preferences, market conditions and economic downturns and often need substantial additional capital to expand or compete. These factors may have an impact on the ultimate recovery of our loans to such businesses. Loans to small businesses, therefore, involve a high degree of business and financial risk, which can result in substantial losses and accordingly should be considered speculative.

– We Have an Ongoing Need for Additional Capital Since Earnings Are Required to be Paid as Dividends

     We will continue to need working capital to fund loans. Historically, we have sold loans receivable, borrowed from financial institutions and issued equity securities. A reduction in the availability of funds from financial institutions, the equity market or the asset-backed securities market could have a material adverse effect on us. We must distribute at least 90% of our investment company taxable income to our shareholders to maintain our RIC status under the Code. As a result, such earnings are not available to fund loan originations. We expect to be able to borrow from financial institutions and sell loans receivable in the asset-backed securities market. We do not anticipate selling additional equity securities at our current market price. If we fail to obtain funds from such sources or from other sources to fund our loans and pay dividends, it could have a material adverse effect on our financial condition and our results of operations. In addition, as a BDC, we are generally required to maintain a ratio of at least 200% of total assets to total borrowings, which restricts our ability to borrow in certain circumstances.

– There May be Significant Fluctuations in Our Quarterly Results

     Our quarterly operating results will fluctuate based on a number of factors, including, among others:

	•		The completion of a structured loan sale transaction in a particular period;
	•		Interest rate changes;
	•		The volume and timing of loan originations and prepayments of our loans receivable;
	•		Changes in the cash flows and/or assumptions underlying the valuation of our Retained Interests;
	•		The recognition of gains or losses on investments;
	•		The level of competition in our markets; and
	•		General economic conditions, especially those which affect the hospitality industry.

     As a result of these factors, results for any quarter should not be relied upon as being indicative of performance in future quarters.

     In addition, to the extent a structured loan sale transaction is completed, (i) our interest income in future periods will be reduced until the proceeds received are reinvested in new loan originations, (ii) interest expense will be reduced if we repay outstanding debt with the proceeds and (iii) we will earn income from our ownership of a retained interest in the loans sold. Until the proceeds are fully reinvested, the net impact of a structured loan sale transaction on future operating periods should be a reduction in interest income, net of interest expense.

– The Loss of Pass-Through Tax Treatment Would Subject Us to Income Taxes

     We intend to continue to qualify as a RIC under the Code. If a company meets certain diversification and distribution requirements under the Code, it qualifies for pass-through tax treatment. We would cease to qualify

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for pass-through tax treatment if we were unable to comply with these requirements or if we ceased to qualify as an investment company under the 1940 Act. We are also subject to a 4% excise tax (and, in certain cases, corporate level income tax) if we fail to make certain distributions. Failure to qualify as a RIC would subject us to Federal income tax as if we were an ordinary corporation, resulting in a substantial reduction in both our net assets and the amount of income available for distribution to our shareholders.

– We Operate in a Highly Regulated Environment

     We are regulated by the SBA and the SEC. In addition, changes in the laws or regulations that govern BDCs, RICs, SBICs and SBLCs may significantly affect our business. Laws and regulations may be changed from time to time, and the interpretations of the relevant laws and regulations are also subject to change. Any change in the laws or regulations governing our business could have a material impact on our financial condition or our results of operations.

EMPLOYEES

     At December 31, 2002, we employed 47 individuals including marketing professionals, investment professionals, operations professionals and administrative staff. Our loan processing is centralized in our Dallas, Texas office. In addition, we have loan production offices in Georgia, Arizona and Missouri. Our management believes the relationship with our employees is good.

     All of our operating assets acquired in liquidation are managed for us by third party management companies. All persons employed in the day-to-day operations of our assets acquired in liquidation are employees of the management companies engaged by us and are not our employees.

     At December 31, 2002, our non-consolidated subsidiary, PMC Funding, employed 14 individuals in relation to the operation of its assisted care living facility. During January 2003, PMC Funding sold the assisted care living facility.

CUSTOMERS

     We are not dependent upon a single borrower, or a few borrowers, whose loss would have a material adverse effect on us. In addition, we have not loaned more than 10% of our assets to any single borrower.

AVAILABLE INFORMATION

     We file annual, quarterly and special reports and other information with the Securities and Exchange Commission (the “SEC”). All documents may be located at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549 or you may obtain information on the operation of the Public Reference Room by calling 1-800-SEC-0330. Our SEC filings are also available to the public, free of charge, at our internet site www.pmccapital.com as soon as reasonably practicable after the reports are filed with, or furnished to, the SEC or at the SEC’s internet site www.sec.gov.

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Item 2. PROPERTIES

     Our headquarters are located at 18111 Preston Road, Suite 600, Dallas, Texas 75252. We lease approximately 13,000 square feet in an office building pursuant to a five-year lease which commenced in December 1998. In addition, at December 31, 2002, we leased office space in Missouri. The aggregate annual lease payments for the year ended December 31, 2002 were approximately $328,000.

Item 3. LEGAL PROCEEDINGS

     We are a party to certain lawsuits in the normal course of our business, including the operation of our assets acquired in liquidation. While the outcome of these legal proceedings cannot at this time be predicted with complete certainty, we do not expect that any of these actions either individually or in the aggregate will have a material effect upon our financial condition or results of operations.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of shareholders during the last quarter of 2002.

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PART II

Item 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT’S COMMON STOCK AND RELATED SHAREHOLDER MATTERS

     Our Common Stock is traded on the American Stock Exchange (“AMEX”) under the symbol “PMC.” The following table sets forth, for the periods indicated, the high and low sales prices as reported on the AMEX and the regular dividends per share declared by us for each such period.

     On March 21, 2003, there were approximately 800 shareholders of record of our Common Stock and the last reported sales price of our Common Stock was $4.25 per share.

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Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

     The following is a summary of our Selected Consolidated Financial Data as of and for the five years in the period ended December 31, 2002. The following data should be read in conjunction with our consolidated financial statements and the notes thereto and “Management’s Discussion and Analysis of the Financial Condition and Results of Operations” appearing elsewhere in this Form 10-K. The selected consolidated financial data presented below has been derived from our consolidated financial statements.