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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Commission file number 814-00149

AMERICAN CAPITAL STRATEGIES, LTD.

2 Bethesda Metro Center
14^th Floor
Bethesda, Maryland 20814
(Address of principal executive offices)

(301) 951-6122
(Registrant's telephone number, including area code)

Securities to be registered pursuant to Section 12(b) of the Act: Not Applicable

Securities registered pursuant to section 12(g) of the Act:

          Indicate by check mark whether the registrant (1) has filed all reports 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 earlier 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 ý. 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 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. o

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ý. No o.

          As of February 28, 2003, the aggregate market value of the Registrant's common stock held by nonaffiliates of the Registrant was approximately $1,159,433,000 based upon a closing price of the Registrant's common stock of $24.70 per share as reported on the NASDAQ Stock Market on that date. (For this computation, the registrant has excluded the market value of all shares of its Common Stock reported as beneficially owned by executive officers and directors of the registrant and certain other stockholders; such an exclusion shall not be deemed to constitute an admission that any such person is an "affiliate" of the registrant.) As of February 28, 2003, there were 48,185,000 shares of the Registrant's common stock outstanding.

          DOCUMENTS INCORPORATED BY REFERENCE. The Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 15, 2003 is incorporated by reference into certain sections of Part III herein.

          Certain exhibits previously filed with the Securities and Exchange Commission are incorporated by reference into Part III of this report.

PART I

Item 1. Business

Background

        American Capital Strategies, Ltd., a Delaware corporation (the "Company"), was incorporated in 1986 to provide financial advisory services to and invest in middle market companies. On August 29, 1997, the Company completed an initial public offering ("IPO") of its common stock and became a non-diversified, closed end investment company that has elected to be regulated as a business development company ("BDC") under the Investment Company Act of 1940, as amended (the "1940 Act"). On October 1, 1997, the Company began operations so as to qualify to be taxed as a regulated investment company ("RIC") as defined in Subtitle A, Chapter 1, under Subchapter M of the Internal Revenue Code of 1986 as amended (the "Code").

        The Company is principally engaged in providing senior debt, subordinated debt and equity to middle market companies in need of capital for management buyouts, including employee stock ownership plan ("ESOP") buyouts, growth, acquisitions, liquidity and restructuring. The Company is the parent of American Capital Financial Services, Inc. ("ACFS"), an operating subsidiary principally engaged in providing financial advisory services to the Company's portfolio companies. The Company's ability to fund the entire capital structure is an advantage in completing middle market transactions. The Company generally invests up to $50 million in each transaction and, through ACFS, will arrange and secure capital for larger transactions. The Company's primary business objectives are to increase its net operating income and net asset value by investing its assets in senior debt, subordinated debt with warrants and equity of middle market companies with attractive current yields and potential for equity appreciation. The Company's loans typically range from $5 million to $35 million, mature in five to ten years, and require monthly or quarterly interest payments at fixed rates or variable rates based on the prime or LIBOR rate, plus a margin. The Company prices its debt and equity investments based on its analysis of each transaction. As of December 31, 2002, the weighted average effective yield on the Company's investments was 10.3%. From its formation in 1986 through the IPO, the Company arranged financing transactions aggregating over $400 million and invested in the equity securities of eight of those transactions. From the IPO through December 31, 2002, the Company invested $277 million in equity securities and over $1.3 billion in debt securities of middle market companies including almost $32 million in funds committed but undrawn under credit facilities.

        The Company generally acquires equity interests in the companies from which it has purchased debt securities with the goal of enhancing its overall return. As of December 31, 2002, the Company had a fully-diluted weighted average ownership interest of 43% in its portfolio companies. The Company is prepared to be a long-term partner to its portfolio companies, thereby positioning the Company to participate in their future financing needs. As of December 31, 2002, the Company has invested $262 million in follow-on investments. In most cases, the Company receives rights to require the business to purchase the warrants and stock held by the Company ("Put Rights") under various circumstances including, typically, the repayment of the Company's loans or debt securities. The Company may use its Put Rights to dispose of its equity interest in a business, although the Company's ability to exercise Put Rights may be limited or nonexistent if a business is illiquid. In most cases, the Company also receives the right to representation on the businesses' board of directors.

        The opportunity to liquidate its investments and realize a gain may occur if the business recapitalizes its equity, such as through a sale to new owners, or a public offering of its equity or if the Company exercises its Put Rights. The Company generally does not have the right to require that a business undergo an initial public offering by registering securities under the Securities Act of 1933, as amended, but the Company generally does have the right to sell its equity interests in a public offering by the business to the extent permitted by the underwriters.

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        The Company makes available significant managerial assistance to its portfolio companies. Such assistance typically involves closely monitoring the operations of the company, hiring additional senior management, if needed, being available for consultation with its officers, assisting in developing the business plan and providing financial guidance and participating on the company's board of directors. Providing assistance to its borrowers serves as an opportunity for the Company to assist in maximizing the value of the portfolio company. At December 31, 2002, the Company had board seats on 61 out of 69 portfolio companies and had board observation rights on six of the remaining portfolio companies in which it has made investments.

        Prior to the IPO, the Company established itself as a leading firm in structuring and obtaining funding for management and employee buyouts of subsidiaries, divisions and product lines being divested by larger corporations through the use of an ESOP. The selling entities have included many nationally recognized companies. In most of the ESOP transactions structured by the Company, the employees agree to restructure their wages and benefits so that overall cash compensation is reduced while contributions of stock are made to an ESOP. The resulting company is structured so that the fair market value of stock contributed to the ESOP can be deducted from corporate income before paying taxes. Restructuring employee compensation together with the ESOP tax advantages has the effect of improving the cash flow of the ESOP company. The Company is a leading firm in structuring and implementing ESOP employee buyouts. The Company believes that its ESOP knowledge and experience and its ability to fund transactions positions the Company favorably in the market place.

        The Company believes that it has established an extensive referral network comprised of private equity and mezzanine funds, investment bankers, attorneys, accountants, commercial bankers, unions, business and financial brokers, and existing ESOP companies. The Company has also developed internet website that generates financing requests and provides businesses an efficient tool for learning about the Company and its capabilities.

        The Company has a marketing department headed by a senior vice president of marketing, dedicated to maintaining contact with members of the referral network and receiving opportunities for the Company to consider. During 2002, the marketing department received information concerning several thousand transactions for consideration. Most of those transactions did not meet the Company's criteria for initial consideration, but the opportunities that met those criteria were sent to the Company's principals for further review and consideration.

        The Company's executive offices are located at 2 Bethesda Metro Center, 14^th Floor, Bethesda, Maryland 20814 and its telephone number is (301) 951-6122. In addition to its executive offices, the Company maintains offices in New York, San Francisco, Los Angeles, Philadelphia, Chicago and Dallas.

        The Company maintains a website at www.americancapital.com. The Company makes available free of charge on its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.

Lending and Investment Decision Criteria

        The Company reviews certain criteria in order to make investment decisions. The criteria listed below provide a general guide for the Company's lending and investment decisions, although not all criteria are required to be favorable in order for the Company to make an investment.

        Operating History.    The Company focuses on target companies that have been in business from 5 to more than 50 years and have stable operating histories including a history of generating positive operating cash flow. The Company will design the target company's capital structure to enable the company to service and repay debt based on the Company's assessment of the company's current and projected operating cash flow. The Company targets companies with significant market share in their products or services relative to their competitors. In addition, the Company considers factors such as

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customer concentration, recession history, competitive environment and ability to sustain margins. The Company does not intend to lend or invest in start-up or other early stage companies, or companies with insufficient cash flows to service debt.

        Growth.    The Company considers a target company's ability to increase its cash flow. Anticipated growth is a key factor in determining the value ascribed to any warrants and equity interests acquired by the Company.

        Liquidation Value of Assets.    Although the Company does not operate as an asset-based lender, liquidation value of the assets collateralizing the Company's loans is an important factor in many credit decisions. Emphasis is placed both on tangible assets such as accounts receivable, inventory, plant, property and equipment as well as intangible assets such as customer lists, networks, databases and recurring revenue streams.

        Experienced Management Team.    The Company requires that a potential recipient of the Company's financing have a management team that has demonstrated the ability to execute the portfolio company's objectives and implement its business plan. The Company also requires that this management team be experienced and properly incentivized through a significant ownership interest in the portfolio company.

        Exit Strategy.    Before making an investment, the Company analyzes the potential for the target company to experience a liquidity event that will allow the Company to realize value for its equity position. Liquidity events include, among other things, a private sale of the Company's financial interest, including a sale to the portfolio company through the exercise of Put Rights, a sale of the portfolio company, an initial public offering or a purchase by the portfolio company or one of its stockholders of the Company's equity position.

Operations

        Marketing and Origination Process.    The Company has 55 investment professionals and 17 accounting professionals involved in evaluating prospective investments and monitoring portfolio companies as of December 31, 2002. To source financing opportunities, the Company has a dedicated marketing department headed by a senior vice president who manages an extensive referral network comprised of private equity and mezzanine funds, investment bankers, attorneys, accountants, commercial bankers, unions, business and financial brokers and existing ESOP companies. The Company also uses its internet website to attract financing opportunities.

        Approval Process.    The Company's financial professionals review informational packages in search of potential financing opportunities and conduct a due diligence investigation of each target company that passes an initial screening process. This due diligence investigation generally includes one or more on-site visits, a review of the target company's historical and prospective financial information, interviews with management, employees, customers and vendors of the target company, background investigations on the management team and research on the target company's products, service and industry. The Company engages professionals such as environmental consultants, accountants, lawyers, risk managers and management consultants to perform elements of the due diligence review as it deems appropriate. Upon completion of a due diligence investigation, one of the Company's principals prepares an investment committee report summarizing the target company's historical and projected financial statements, industry, and management team and analyzing its conformity to the Company's general investment criteria. The principal then presents this profile to the Company's Investment Committee. The Company's policy calls for the Investment Committee to approve each financing and the Board of Directors to approve each financing in excess of $0.5 million.

        Portfolio Management.    In addition to the review at the time of original underwriting, the Company attempts to preserve and enhance the earnings quality of its portfolio companies through

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proactive management of its relationships with its portfolio companies. This process includes attendance at portfolio company board meetings, management consultation and review and management of covenant compliance. The Company's investment and finance personnel regularly review portfolio company monthly financial statements to assess cash flow performance and trends, periodically evaluate the operations of the client, seek to identify industry or other economic issues that may adversely affect the client, and prepare quarterly summaries of the aggregate portfolio quality for management review.

        Operations Team.    The Company also has a group of management and accounting professionals dedicated to certain of its portfolio companies that require more extensive assistance with developing business plans, marketing strategies, product positioning, recruiting appropriate management personnel and evaluating cost structures. These portfolio companies may be peforming below the Company's original expectation at the time of the Company's initial investment, but the portfolio company may still have solid product lines or customer bases but require management assistance in regaining market share or controlling costs. The operations team will work closely with the portfolio company and, in many instances, members of the operations team will assist on-site at the portfolio company with the day-to-day operations of the portfolio company.

Loan Grading

        The Company evaluates and classifies all loans based on their current risk profiles. The process requires the Director of Portfolio Monitoring to grade a loan on a scale of 1 to 4 each quarter. Loans graded 4 involve the least amount of risk of loss, while loans graded 1 have the highest risk of loss. The loan grade is then reviewed and approved by the Investment Committee and the Board of Directors. This loan grading process is intended to reflect the performance of the portfolio company's business, the collateral coverage of the loans and other factors considered relevant. For more information regarding the Company's loan grading practices, see "Management's Discussion and Analysis of Financial Condition and Results of Operations—Portfolio Credit Quality."

Competition

        The Company competes with a large number of private equity and mezzanine funds, investment banks and other equity and non-equity based investment funds, and other sources of financing, including traditional financial services companies such as commercial banks. Some of the Company's competitors are substantially larger and have considerably greater financial resources than the Company. Competitors may have lower cost of funds and many have access to funding sources that are not available to the Company. In addition, certain of the Company's competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships and build their market shares. There is no assurance that the competitive pressures the Company faces will not have a material adverse effect on its business, financial condition and results of operations. In addition, because of this competition, the Company may not be able to take advantage of attractive investment opportunities from time to time and there can be no assurance that the Company will be able to identify and make investments that satisfy its investment objectives or that the Company will be able to meet its investment goals.

Employees

        As of December 31, 2002, the Company had 108 employees. The Company's employees consist of 55 investment professionals, 17 accounting professionals involved in evaluating prospective investments and monitoring portfolio companies, 15 corporate finance and accounting professionals, 6 information technology professionals, and 15 administrative staff personnel. The Company believes that its relations with its employees are excellent.

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The Company's Operations as a BDC and RIC

        As a BDC, the Company may not acquire any asset other than "Qualifying Assets", as defined by the 1940 Act, unless, at the time the acquisition is made, Qualifying Assets represent at least 70% of the value of the Company's total assets. The principal categories of Qualifying Assets relevant to the business of the Company are the following:

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securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer is an eligible portfolio company. An eligible portfolio company is defined as 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 a small business investment company wholly-owned by the BDC, and (c) does not have any class of publicly-traded securities with respect to which a broker may extend credit;



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



•

cash, cash items, Government securities, or high quality debt securities maturing in one year or less from the time of investment.

        The Company may not change the nature of its business so as to cease to be, or withdraw its election as, a BDC unless authorized by vote of the holders of the majority, as defined in the 1940 Act, of the Company's outstanding voting securities. Since the Company made its BDC election, it has not made any substantial change in its structure or in the nature of its business.

        The Company operates so as to qualify as a RIC under the Code. Generally, in order to qualify as a RIC, the Company must continue to qualify as a BDC and distribute to shareholders in a timely manner, at least 90% of its "investment company taxable income" as defined by the Code. Also, the Company must derive at least 90% of its 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 its business of investing in such stock or securities as defined by the Code. Additionally, the Company must diversify its holdings so that (a) at least 50% of the value of the Company's 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 the Company's assets and 10% of the outstanding voting securities of the issuer and (b) no more than 25% of the value of the Company's assets (including those owned by ACFS) are invested in the securities of one issuer (other than U.S. government securities and securities of other RICs), or of two or more issuers that are controlled by the Company and are engaged in the same or similar or related trades or businesses. Since the Company qualifies as a RIC, it is not subject to Federal income tax on the portion of its taxable income and net capital gains it distributes in a timely fashion to stockholders. In addition, with respect to each calendar year, if the Company distributes or is treated as having distributed (including amounts retained but designated as deemed distributed) in a timely manner 98% of its capital gain net income for each one-year period ending on October 31, and distributes 98% of its net ordinary income for such calendar year (as well as any income not distributed in prior years), it will not be subject to the 4% nondeductible Federal excise tax imposed with respect to certain undistributed income of RICs.

        If the Company fails to satisfy the 90% distribution requirement or otherwise fails to qualify as a RIC in any taxable year, it will be subject to tax in such year on all of its taxable income, regardless of whether the Company makes any distribution to its stockholders. In addition, in that case, all of the Company's distributions to its shareholders will be characterized as ordinary income (to the extent of the Company's current and accumulated earnings and profits).

        The Company's wholly-owned subsidiary, ACFS, is a corporation under Subchapter C of the Code and is subject to corporate level Federal and state income tax.

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Temporary Investments

        Pending investment in other types of Qualifying Assets, the Company has invested its otherwise uninvested cash primarily in cash, cash items, government securities, agency paper or high quality debt securities maturing in one year or less from the time of investment in such high quality debt investments ("Temporary Investments") so that at least seventy percent (70%) of its assets are Qualifying Assets. Typically, the Company invests in U.S. Treasury bills. Additionally, the Company may invest in repurchase obligations of a "primary dealer" in government securities (as designated by the Federal Reserve Bank of New York) or of any other dealer whose credit has been established to the satisfaction of the Board of Directors. There is no percentage restriction on the proportion of the Company's assets that may be invested in such repurchase agreements. A repurchase agreement involves the purchase by an investor, such as the Company, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed upon future date and at a price which is greater than the purchase price by an amount that reflects an agreed-upon interest rate. Such interest rate is effective for the period of time during which the investor's money is invested in the arrangement and is related to current market interest rates rather than the coupon rate on the purchased security. The Company requires the continual maintenance by its custodian or the correspondent in its account with the Federal Reserve/Treasury Book Entry System of underlying securities in an amount at least equal to the repurchase price. If the seller were to default on its repurchase obligation, the Company might suffer a loss to the extent that the proceeds from the sale of the underlying securities were less than the repurchase price. A seller's bankruptcy could delay or prevent a sale of the underlying securities.

Leverage

        For the purpose of making investments and to take advantage of favorable interest rates, the Company has issued, and intends to continue to issue, senior debt securities and other evidences of indebtedness, up to the maximum amount permitted by the 1940 Act, which currently permits the Company, as a BDC, to issue senior debt securities and preferred stock (collectively, "Senior Securities") in amounts such that the Company's asset coverage, as defined in the 1940 Act, is at least 200% after each issuance of Senior Securities. Such indebtedness may also be incurred for the purpose of effecting share repurchases. As a result, the Company is exposed to the risks of leverage. Although the Company has no current intention to do so, it has retained the right to issue preferred stock. As permitted by the 1940 Act, the Company may, in addition, borrow amounts up to five percent (5%) of its total assets for temporary purposes.

Investment Objectives and Policies

        The Company's investment objectives are to achieve a high level of current income from the collection of interest, dividends and related fees, as well as long-term growth in its shareholders' equity through the appreciation in value of the Company's equity interests in the portfolio companies in which it invests. The following restrictions, along with these investment objectives, are the Company's only fundamental policies—that is, policies that may not be changed without the approval of the holders of the majority, as defined in the 1940 Act, of the Company's outstanding voting securities. The percentage restrictions set forth below other than the restriction pertaining to the issuance of Senior Securities, as well as those contained elsewhere herein, apply at the time a transaction is effected, and a subsequent change in a percentage resulting from market fluctuations or any cause other than an action by the Company will not require the Company to dispose of portfolio securities or to take other action to satisfy the percentage restriction:

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the Company will at all times conduct its business so as to retain its status as a BDC. In order to retain that status, the Company may not acquire any assets (other than non-investment assets necessary and appropriate to its operations as a BDC) if after giving effect to such acquisition the value of its Qualifying Assets amounts to less than 70% of the value of its total assets. For a

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summary definition of Qualifying Assets, see "The Company's Operations as a BDC and RIC." The Company believes that most of the securities it proposes to acquire (provided that the Company controls, or through its officers or other participants in the financing transaction, makes significant managerial assistance available to the issuers of these securities), as well as Temporary Investments, will generally be Qualifying Assets. Securities of public companies, on the other hand, are generally not Qualifying Assets unless they were acquired in a distribution, in exchange for or upon the exercise of a right relating to securities that were Qualifying Assets.

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the Company may invest up to 100% of its assets in securities acquired directly from issuers in privately-negotiated transactions. With respect to such securities, the Company may, for the purpose of public resale, be deemed an "underwriter" as that term is defined in the 1933 Act. The Company may invest up to 50% of its assets to acquire securities of issuers for the purpose of acquiring control (up to 100% of the voting securities) of such issuers. The Company will not concentrate its investments in any particular industry or group of industries. Therefore, the Company will not acquire any securities (except upon the exercise of a right related to previously acquired securities) if, as a result, 25% or more of the value of its total assets (including assets held by ACFS) consists of securities of companies in the same industry.



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the Company may issue Senior Securities to the extent permitted by the 1940 Act for the purpose of making investments, to fund share repurchases, or for temporary or emergency purposes. As a BDC, the Company may issue Senior Securities up to an amount so that the asset coverage, as defined in the 1940 Act, is at least 200% immediately after each issuance of Senior Securities.



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the Company will not (a) act as an underwriter of securities of other issuers (except to the extent that it may (i) be deemed an "underwriter" of securities purchased by it that must be registered under the 1933 Act before they may be offered or sold to the public or (ii) underwrite securities to be distributed to or purchased by stockholders of the Company in connection with offerings of securities by companies in which the Company is a stockholder); (b) purchase or sell real estate or interests in real estate or real estate investment trusts (except that the Company may purchase and sell real estate or interests in real estate in connection with the orderly liquidation of investments and may own the securities of companies or participate in a partnership or partnerships that are in the business of buying, selling or developing real estate); (c) sell securities short (except with regard to managing risks associated with publicly traded securities issued by portfolio companies); (d) purchase securities on margin (except to the extent that it may purchase securities with borrowed money); (e) write or buy put or call options (except (i) to the extent of warrants or conversion privileges in connection with its acquisition financing or other investments, and rights to require the issuers of such investments or their affiliates to repurchase them under certain circumstances, or (ii) with regard to managing risks associated with publicly traded securities issued by portfolio companies); (f) engage in the purchase or sale of commodities or commodity contracts, including futures contracts (except where necessary in working out distressed loan or investment situations); or (g) acquire more than 3% of the voting stock of, or invest more than 5% of its total assets in any securities issued by, any other investment company, except as they may be acquired as part of a merger, consolidation or acquisition of assets. With regard to that portion of the Company's investments in securities issued by other investment companies it should be noted that such investments may subject the Company's shareholders to additional expenses.

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Investment Advisor

        The Company has no investment advisor and is internally managed by its executive officers under the supervision of the Board of Directors.

Item 2. Properties

        Neither the Company nor its subsidiary owns any real estate or other physical properties materially important to the operation of the Company or its subsidiary. The Company and its subsidiary lease office space in seven locations for terms ranging up to eight years.

Item 3. Legal Proceedings

        Although the Company and its subsidiary may, from time to time, be involved in litigation and claims arising out of their operations in the normal course of business, as of December 31, 2002, the Company and its subsidiary were not presently parties to any material pending legal proceedings.

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

        During the fourth quarter of the fiscal year ended December 31, 2002, there were no matters submitted to a vote of the Company's security holders through the solicitation of proxies or otherwise.

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PART II

Item 5. Market for Registrant's Common Equity and Related Shareholder Matters

        Since the IPO, the Company has distributed, and currently intends to continue to distribute in the form of dividends, a minimum of 90% of its investment company taxable income on a quarterly basis to its shareholders. Net realized long-term capital gains may be retained to supplement the Company's equity capital and support growth in its portfolio, unless the Board of Directors determines in certain cases to make a distribution. There is no assurance that the Company will achieve investment results or maintain a tax status that will permit any specified level of cash distributions or year-to-year increases in cash distributions.

        The Company's common stock is quoted on the Nasdaq Stock Market under the symbol ACAS. As of March 3, 2003, the Company had 501 shareholders of record and approximately 66,400 beneficial owners. The following table sets forth the range of high and low sales prices of the Company's common stock as reported on the Nasdaq Stock Market and the dividends declared by the Company for the period from January 1, 1998 through March 3, 2003.

(1)

Includes extra dividend of $0.11.

(2)

Includes extra dividend of $0.03.

(3)

Includes extra dividend of $0.22.

(4)

Includes extra dividend of $0.09.

(5)

Includes extra dividend of $0.02.

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Item 6. Selected Financial Data

AMERICAN CAPITAL STRATEGIES, LTD.
Consolidated Selected Financial Data

        The selected financial data should be read in conjunction with the Company's consolidated financial statements and notes thereto.

(1)

Principal amount of loan repayments includes the collection of payment-in-kind notes and accreted loan discounts.

(2)

Calculated before the effect of net (depreciation) appreciation on investments. Average equity is calculated based on the quarterly shareholders' equity balances.

(3)

Return represents net increase (decrease) in shareholders' equity resulting from operations.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
(Dollars in thousands except per share data)

Management's Discussion and Analysis of Financial Condition and Results of Operations

        All statements contained herein that are not historical facts including, but not limited to, statements regarding anticipated activity are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among the factors that could cause actual results to differ materially are the following: (i) changes in the economic conditions in which the Company operates negatively impacting the financial resources of the Company; (ii) certain of the Company's competitors with substantially greater financial resources than the Company reducing the number of suitable investment opportunities offered to the Company or reducing the yield necessary to consummate the investment;(iii) volatility in the value of equity investments; (iv) increased costs related to compliance with laws, including environmental laws; (v) changes in the economic conditions that could cause the Company's portfolio companies to default on their loans or provide no returns on the Company's investments; (vi) changes in the underlying assumptions used to value the Company's privately held securities; (vii) ability of the Company to obtain additional financing; (viii) ability of the Company to retain key management personnel; and (ix) general business and economic conditions and other risk factors described in the Company's reports filed from time to time with the Securities and Exchange Commission. The Company cautions readers not to place undue reliance on any such forward-looking statements, which statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made.

        The following analysis of the financial condition and results of operations of the Company should be read in conjunction with the Company's consolidated financial statements and the notes thereto.

Portfolio Composition

        The Company's primary business is investing in and lending to businesses through investments in senior debt, subordinated debt generally with detachable equity warrants, preferred stock, and common stock. The total portfolio value of investments in publicly and non-publicly traded securities was $1,248,459 and $858,266 at December 31, 2002 and 2001, respectively. During the years ended December 31, 2002, 2001, 2000, the Company made investments totaling $573,500, $389,300 and $275,500, including $20,900, $6,500 and $9,500, in funds committed but undrawn under credit facilities, respectively. The weighted average effective interest rate on debt securities was 12.5%, 13.9% and 14.6%, at December 31, 2002, 2001, and 2000, respectively.

        The Company's strategy for investing in new portfolio companies is to invest capital in the following three types of transactions: i) providing senior debt, mezzanine debt and equity and serving as a financial partner in management and employee buyouts, ii) providing mezzanine and senior debt financing for buyouts led by private equity firms, and iii) providing mezzanine and senior debt directly to private and small public companies.

        The Company seeks to be a long-term partner with its portfolio companies. As a long-term partner, the Company will invest capital in a portfolio company subsequent to the initial investment if the Company believes that it can achieve appropriate returns for its investment. Add-on financings fund i) strategic acquisitions by the portfolio company of either a complete business or specific lines of a business that are related to the portfolio company's business, ii) recapitalization at the portfolio company, iii) growth at the portfolio company such as product development or plant expansions, or iv) working capital for portfolio companies that need capital to fund operating costs, debt service, or growth in receivables or inventory.

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        The Company's investments during the years ended December 31, 2002, 2001 and 2000 were as follows:

Critical Accounting Policies

Valuation of Investments

        The Company values its investment portfolio each quarter. The portfolio analysts in the Company's finance department prepare the portfolio company valuations each quarter using the most recent portfolio company financial statements and forecasts. These analysts will also consult with the respective principal who is managing the portfolio investment relationship to obtain further updates on the portfolio company performance, including information such as industry trends, new product development, and other operational issues. The valuations are reviewed by the Company's investment committee and audit committee of the Board of Directors and presented to the Board of Directors, which reviews and approves the portfolio valuations in accordance with the following valuation policy.

        Investments are carried at fair value, as determined by the Board of Directors. Securities that are publicly traded are valued at the closing price on the valuation date. For debt and equity securities that are not publicly traded, or for which the Company has various degrees of trading restrictions, the Company prepares an analysis consisting of traditional valuation methodologies to estimate the enterprise value of the portfolio company issuing the securities. The methodologies consist of valuation estimates based on: valuations of comparable public companies, recent sales of comparable companies, discounting the forecasted cash flows of the portfolio company and the liquidation value of the company's assets. The Company will use weighting of some or all of the above valuation methods. In valuing convertible debt, equity or other securities, the Company will value its equity investment based on its pro rata share of the residual equity value available after deducting all outstanding debt from the estimated enterprise value. The Board of Directors will value non-convertible debt securities at cost plus amortized original issue discount ("OID") to the extent that the estimated enterprise value of the portfolio company exceeds the outstanding debt of the company. If the estimated enterprise value is less than the outstanding debt of the company, the Board of Directors will reduce the value of the Company's debt investment beginning with the junior most debt such that the enterprise value less the value of the outstanding debt is zero. If there is sufficient enterprise value to cover the face amount of a debt security that has been discounted due to the detachable equity warrants received with that security, that detachable equity warrant will be valued such that the sum of the discounted debt security and the detachable equity warrant equal the face value of the debt security. Due to the uncertainty inherent in the valuation process, such estimates of fair value may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. Additionally, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.

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Interest and Dividend Income Recognition

        Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. OID is accreted into interest income using the effective interest method. OID initially represents the value of detachable equity warrants obtained in conjunction with the acquisition of debt securities. Loan origination fees collected upon the funding of a loan are deferred and accreted into interest income over the life of the loan using the effective interest method. Dividend income is recognized on the ex-dividend date. The Company stops accruing interest on its investments when it is determined that interest is no longer collectible. The Company will place a loan on non-accrual status if the loan has been impaired as determined by the portfolio company valuation. For loans with payment-in-kind ("PIK") interest features, the Company bases income accruals on the valuation of the PIK notes received from the borrower. If the portfolio company valuation indicates a value of the PIK notes that is not sufficient to cover the contractual interest, the Company will not accrue interest income on the notes.

Fee Income Recognition

        Fees primarily include financial advisory, transaction structuring, financing and prepayment premiums. Financial advisory fees represent amounts received for providing advice and analysis to middle market companies and are recognized as earned based on services provided. Transaction structuring and financing fees represent amounts received for structuring, financing, and executing transactions and are generally payable only if the transaction closes and are recognized as earned when the transaction is completed. Prepayment premiums are recognized as they are received.

Results of Operations

        The Company's consolidated financial performance, as reflected in its Consolidated Statements of Operations, is composed of three primary elements. The first element is "Net operating income," which is primarily the interest and dividends earned from investing in debt and equity securities and financial advisory, transaction structuring, financing and prepayment and other fees, less the operating expenses of the Company. The second element is "Net urealized (depreciation) appreciation of investments," which is the net change in the estimated fair values of the Company's portfolio investments at the end of the period compared with their estimated fair values at the beginning of the period or their stated costs, as appropriate. The third element is "Net realized (loss) gain on investments," which reflects the difference between the proceeds from a sale or maturity of a portfolio investment and the cost at which the investment was carried on the Company's Consolidated Balance Sheets.

        The consolidated operating results for the years ended December 31, 2002, 2001, and 2000 are as follows:

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Fiscal Year 2002 Compared to Fiscal Year 2001

Operating Income

        Total operating income is comprised of two components: interest and dividend income and fees. For the year ended December 31, 2002 ("2002"), total operating income increased $42,785, or 41%, over the year ended December 31, 2001 ("2001"). Interest and dividend income consisted of the following for the years ended December 31, 2002 and December 31, 2001:

        In 2002, interest income on debt securities increased by $42,467, or 49% to $129,180. Interest and dividend income is affected by both the level of net new investments and by changes in the one-month London Interbank Offered Rate ("LIBOR") and prime lending rates. The Company's daily weighted average debt investment at cost increased from $614,817 in 2001 to $950,513 in 2002 resulting from new loan originations of $480,226, net of loan repayments totaling $113,680. The daily weighted average interest rate on debt securities decreased to 13.6% in 2002 from 14.1% in 2001 due primarily to a decrease in the weighted average prime lending rate from 6.33% in 2001 to 4.68% in 2002. To match the interest rate basis of its assets and liabilities and to fulfill its obligations under the terms of its revolving debt funding facility and term securitizations, the Company enters into interest rate swap agreements in which it either pays a floating rate based on the prime rate and receives a floating rate based on LIBOR, or pays a fixed rate and receives a floating rate based on LIBOR. Use of the interest rate swaps enables the Company to lock in the spread between the yield on in its investments and the cost of its borrowings. As a result, both interest income and interest expense are affected by changes in LIBOR. See "Interest Rate Risk" for a discussion of the Company's use of interest rate swaps to mitigate the impact of interest rate changes on net operating income. The negative impact of the interest rate swap agreements increased by $9,305 to $11,153 in 2002 due primarily to an increase in the average quarterly notional amount from $266,785 in 2001 to $496,653 in 2002 as well as a decrease in the average monthly LIBOR rate from 3.70% in 2001 to 1.76% in 2002. Dividend income on equity securities increased by $904, or 50%, to $2,726 due primarily to an increase in the overall investments in preferred stock in 2002 as compared to 2001.

        Fee income consisted of the following for the years ended December 31, 2002 and December 31, 2001:

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        In 2002, fee income increased by $9,003, or 56%, to $24,954. The increase in the transaction structuring fees was the result of closing ten buyout transactions totaling $245,300 in 2002 compared to four buyout transactions totaling $106,000 in 2001. The transaction structuring fees were 2.7% and 3.3% of new buyout investments in 2002 and 2001, respectively. The increase in financing fees was attributable to an increase in loan originations from $331,300 in 2001 to $480,226 in 2002. The financing fees were 2.1% and 2.4% of loan originations in 2002 and 2001, respectively. The increase in financial advisory and other fees is due to the total dollar volume of new investments in 2002 as compared to 2001 as well as the number of portfolio companies under management in 2002.

Operating Expenses

        Operating expenses for 2002 increased $11,861, or 36%, over 2001. The increase is primarily due to an increase in interest expense from $10,343 in 2001 to $14,321 in 2002, an increase in salaries and benefits expense from $14,571 in 2001 to $18,621 in 2002 and an increase in general and administrative expenses from $7,698 in 2001 to $11,531 in 2002. Interest expense increased due to an increase in the Company's weighted average borrowings from $175,600 in 2001 to $416,800 in 2002, net of a decrease in the weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 5.9% in 2001 to 3.4% in 2002. As discussed above, the decrease in the weighted average interest rate is due to a decrease in the average monthly LIBOR rate from 3.70% in 2002 to 1.76% in 2001. Salaries and benefits expense increased due primarily to an increase in employees from 68 at December 31, 2001 to 108 at December 31, 2002. General and administrative expenses increased primarily due to higher facilities expenses, insurance, Board of Directors fees, and financial reporting expenses.

Net Realized (Losses) Gains

        The Company recorded a net realized loss of $20,741 in 2002 and recorded a net realized gain of $5,369 in 2001.

        In September 2002, the Company exited its investment in Goldman Industrial Group ("Goldman") as a result of the sale of certain of Goldman's assets under Section 363 of the Bankruptcy Code. Those assets were related to the sale of Bridgeport Machines, Ltd ("BML") and the intellectual property, brand name, and other intangible assets of Bridgeport Machines, Inc. ("Certain Assets of BMI" and collectively with "BML", the "Bridgeport Assets"). In 2000, The Company made a $30,000 investment consisting of subordinated debt with common stock warrants in Goldman. The Company had recorded an unrealized loss of $3,937 in 2001 and an unrealized loss of $21,246 in 2002 for a cumulative unrealized loss of $25,183 through the second quarter of 2002 to adjust the Company's carrying value to fair value. The Company recognized a net realized loss of $25,578 in 2002 on its investments in $25,000 of the subordinated debt and common stock warrants and recorded an unrealized gain of $3,937 to reverse the previously recorded prior year unrealized loss. Goldman's Bridgeport Assets were purchased by BPT Holdings, Inc. ("BPT"), which was capitalized with $18,000 from the Company in the form of senior debt, preferred stock and common stock and the assumption of the $30,000 subordinated debt from Goldman. Of that $30,000 investment, $5,000 of the Company's investment in Goldman was directly in BML, which was not a party to the Goldman bankruptcy. This investment continues to be recorded at a value of $5,000. The $25,000 balance of the Goldman investment was exchanged for securities in BPT that were deemed to not have any value and were therefore treated as a realized loss.

        During 2002, the Company exited its investment in Decorative Surfaces International, Inc. ("DSI") through a sale of DSI's assets under Section 363 of the Bankruptcy Code. The Company recognized a net realized loss of $1,353 in 2002 on its investments in the subordinated debt, preferred stock, and common stock of DSI, which had a cumulative cost basis of $23,466, and recorded an unrealized gain of $5,352 to reverse the previously recorded prior year unrealized loss. The DSI assets were purchased

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by American Decorative Surfaces International, Inc. ("ADSI"), which was capitalized by the Company through ADSI's assumption of $24,502 of the Company's subordinated debt investment in DSI at par and by a $13,700 cash investment by the Company in the preferred stock of ADSI.

        During 2002, the Company exited its investment in Middleby Corporation through a sale of its common stock warrants and the prepayment of its subordinated debt. The Company received $28,216 in total proceeds from the sale and recognized a net realized gain of $2,444. The realized gain was comprised of $2,278 of unamortized OID on the subordinated debt and $166 of gain on the common stock warrants. In addition, the Company received a prepayment fee of $1,021 in 2002.

        During 2002, the Company exited its investment in IGI, Inc. through a sale of its common stock warrants and the prepayment of its subordinated debt. The Company received $8,323 in total proceeds from the sale and recognized a net realized gain of $1,300. The realized gain was comprised of $1,705 of unamortized OID on the subordinated debt, net of a $405 loss on the common stock warrants. In addition, the Company received a prepayment fee of $223 in 2002.

        During 2002, the Company exited its senior debt and common stock warrant investments in Biddeford Textile Corp ("BTC") in connection with a conveyance of BTC's assets under a plan of reorganization under Chapter 11 of the Bankruptcy Code. The Company recognized a net realized loss of $1,100 in 2002 on its senior debt and common stock warrants investment, which had a cost basis of $3,632, and recorded an unrealized gain of $1,100 to reverse the previously recorded prior year unrealized loss. The assets securing the corporation's BTC debt were conveyed to Biddeford Real Estate Holdings, Inc. ("BREH"), which was capitalized by the Company with senior debt and equity investments.

        During 2002, the Company exited its investment in Crosman Corporation through a sale of its common stock warrants and the prepayment of its subordinated debt. The Company received $4,854 in total proceeds from the sale and recognized a net realized gain of $363. The realized gain was comprised of $265 of unamortized OID on the subordinated debt and $98 of gain on the common stock warrants.

        During 2002, the Company exited its investment in JAAGIR, LLC through a sale of its common stock warrants and the prepayment of its subordinated debt. The Company received $3,398 in total proceeds from the sale and recognized a net realized gain of $79. The realized gain was comprised of $150 of unamortized OID on the subordinated debt, net of a $71 loss on the common stock warrants.

        During 2002, the Company also recognized realized gains of $2,425, $673 and $55, respectively, from the realization of unamortized OID on the prepayment of debt by Weston ACAS Holdings, Inc. ("Weston"), Omnova Solutions, Inc. and PaR Systems, Inc., respectively. In addition, the Company received a prepayment fee of $235 in 2002 related to the prepayment by Weston. The Company also recognized a realized loss of $37 on the cancellation of common stock warrants in Dixie Trucking Company, Inc. The Company also recognized a realized loss of $40 in 2002 on the sale of common stock of o2wireless Solutions, Inc. ("o2wireless") through a cashless exercise of the common stock warrants. During 2002, the Company also sold a portion of its shares of common stock in Gladstone Capital Corporation and recognized a realized gain of $29.

        During 2001, the Company exited its investment in Cornell Companies, Inc. ("Cornell") through a sale of its common stock warrants and the prepayment of its subordinated debt. The Company recognized a net realized gain of $2,140. The realized gain was comprised of a $967 realization of unamortized OID on the subordinated debt, $883 of gain on the common stock warrants, and $290 on the realization of unaccreted loan fees. In December 2001, the Company sold its investment in BIW Connector Systems, LLC ("BIW"). The Company's investment in BIW included senior debt and senior subordinated debt with common stock warrants. The Company recognized a net realized gain of $1,823 which was comprised of a $217 realization of OID on the subordinated debt, $1,405 of gain on the

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common stock warrants, and $201 on the realization of unaccreted loan fees. The Company converted its common stock investment in Mobile Tool, Inc. to subordinated debt by exercising its put rights and recognized a realized gain of $2,452 on this conversion. The Company realized losses of $500 and $592 on the write-off of its common stock investments on the sale of Erie Forge, and on Biddeford Textile Corp., which filed for bankruptcy protection under Chapter 11. The Company sold its common stock warrants in The L.A. Studios, Inc. and recognized a net realized gain of $24 which was comprised of a $126 realization of unamortized OID, and a $102 loss on the common stock warrants.

Unrealized Appreciation and Depreciation of Investments

        The net unrealized depreciation and appreciation of investments is based on portfolio asset valuations determined by the Company's Board of Directors. The following table itemizes the change in net unrealized (depreciation) appreciation of investments and the net realized (losses) gains for the fiscal years ended December 31, 2002 and December 31, 2001:

        The gross unrealized depreciation of investments above includes $1,128 and $818 for 2002 and 2001, respectively, resulting from the change in accounting principle adopted by the Company during fiscal year 2001 related to debt discounts attributable to loan originations through December 31, 2000. The number of companies above does not include investments which include unrealized depreciation solely due to the accounting change.

        The fair value of the interest rate swap agreements represents the fee to either party to terminate the agreements as of a specified date based on the early termination provisions in the respective agreements. A negative fair value would represent the fee the Company would have to pay the other party and a positive fair value would represent the fee the Company would receive from the other party to terminate the agreement. The fair value of the interest rate swap agreements will resolve to zero if held to maturity.

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Fiscal Year 2001 Compared to Fiscal Year 2000

Operating Income

        Total operating income is comprised of two components: interest and dividend income and fees. For 2001, total operating income increased $34,185, or 49%, over the year ended December 31, 2000 ("2000"). Interest and dividend income consisted of the following for the years ended December 31, 2001 and December 31, 2000:

        In 2001, interest income on debt securities increased by $30,544, or 54% to $86,713. Interest income is affected by both the level of net new investments and by changes in the one-month London Interbank Offered Rate ("LIBOR") and prime lending rates. The Company's daily weighted average debt investment at cost increased from $376,202 in 2000 to $614,817 in 2001 resulting from new loan originations of $331,300, net of loan repayments totaling $73,494. The daily weighted average interest rate decreased to 14.1% in 2001 from 14.9% in 2000 due primarily to a decrease in the prime lending rate from 9.50% at December 31, 2000 to 4.75% at December 31, 2001. To match the interest rate basis of its assets and liabilities and to fulfill its obligations under the terms of its revolving debt funding facility and term securitizations, the Company enters into interest rate swap agreements in which it either pays a floating rate based on the prime rate and receives a floating rate based on LIBOR, or pays a fixed rate and receives a floating rate based on LIBOR. Use of the interest rate swaps enables the Company to lock in the spread between the yield on in its investments and the cost of its borrowings. As a result, both interest income and interest expense are affected by changes in LIBOR. See "Interest Rate Risk" for a discussion of the Company's use of interest rate swaps to mitigate the impact of interest rate changes on net operating income. The negative impact of the interest rate swap agreements was $1,848 in 2001 due primarily to an increase in the average notional amount and an increase in the average monthly LIBOR rate. Dividend income on equity securities increased by $953, or 110%, to $1,822 due primarily to an increase in the overall investments in preferred stock in 2001 from 2000.

        Fee income consisted of the following for the years ended December 31, 2001 and December 31, 2000:

        In 2001, fee income increased by $4,632, or 41%, to $15,951. The increase in the transaction structuring fees was the result of closing four buyout transactions totaling $106,000 in 2001 compared

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to five buyout transactions totaling $92,700 in 2000. The transaction structuring fees were 3.3% and 1.6% of new buyout investments in 2002 and 2001, respectively. The increase in financing fees was attributable to an increase in loan originations from $257,509 in 2000 to $331,300 in 2001. The financing fees were 2.4% and 2.8% of loan originations in 2001 and 2000, respectively. The decrease in the loan origination fees as a percentage of the loan originations in 2001 is due to the adoption of change in accounting principle in 2001 that required the Company to accrete loan origination fees over the life of the investment using the effective interest method. In 2000, the Company recognized the loan origination fees when they were collected. The increase in financial advisory and other fees is due to the total dollar volume of new investments in 2001 as well as the number of portfolio companies under management in 2001.

Operating Expenses

        Operating expenses for 2001 increased $5,230, or 19%, over 2000. The increase is primarily due to an increase in salaries and benefits expense from $11,259 in 2000 to $14,571 in 2001 and an increase in general and administrative expenses from $6,432 in 2000 to $7,698 in 2001. Operating expenses for 2001 consisted of $14,571 in salaries and benefits, $7,698 in general and administrative expenses, and $10,343 in interest expense. Interest expense increased due to an increase in the Company's weighted average borrowings from $97,600 in 2000 to $175,600 in 2001, net of a decrease in the weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 9.9% in 2000 to 5.9% in 2001. General and administrative expenses increased primarily due to higher facilities expenses, insurance, Board of Directors fees, and financial reporting expenses. Salaries and benefits expense increased due to an increase in employees from 58 at December 31, 2000 to 68 at December 31, 2001 and an increase in incentive compensation awarded from $5,724 awarded during 2000 to $6,181 awarded in 2001.

Net Realized Gains

        The Company recorded net realized gains of $5,369 and $4,539 in 2001 and 2000, respectively.

        During 2001, the Company exited its investment in Cornell through a sale of its common stock warrants and the prepayment of its subordinated debt. The Company recognized a net realized gain of $2,140. The realized gain was comprised of a $967 realization of unamortized original issue discount ("OID") on the subordinated debt, $883 of gain on the common stock warrants, and $290 on the realization of unaccreted loan fees. In December 2001, the Company sold its investment in BIW. The Company's investment in BIW included senior debt and senior subordinated debt with common stock warrants. The Company recognized a net realized gain of $1,823 which was comprised of a $217 realization of OID on the subordinated debt, $1,405 of gain on the common stock warrants, and $201 on the realization of unaccreted loan fees. The Company converted its common stock investment in Mobile Tool, Inc. to subordinated debt by exercising its put rights and recognized a realized gain of $2,452 on this conversion. The Company realized losses of $500 and $592 on the write-off of its common stock investments on the sale of Erie Forge, and on BTC, which filed for bankruptcy protection under Chapter 11. The Company sold its common stock warrants in The L.A. Studios, Inc. and recognized a net realized gain of $24 which was comprised of a $126 realization of unamortized OID, and a $102 loss on the common stock warrants.

        During 2000, one of the Company's portfolio companies, o2wireless, completed an initial public offering. In conjunction with the offering, o2wireless repaid the Company's $13,000 subordinated note. In addition, the Company exercised and sold 180 of the 2,737 common stock warrants it owns. As a result of these transactions, the Company recorded a realized gain of $4,303 which was comprised of $2,475 of previously unamortized OID and $1,828 of gain on the sale of the exercised warrants.

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Unrealized Appreciation and Depreciation of Investments

        The net unrealized depreciation and appreciation of investments is based on portfolio asset valuations determined by the Company's Board of Directors. The following table itemizes the change in net unrealized (depreciation) appreciation of investments and the net realized gains for the fiscal years ended December 31, 2001 and December 31, 2000:

        Capital.com, an Internet finance portal, was launched in July 1999 under the name AmericanCapitalOnline.com. In December 1999, the assets of AmericanCapitalOnline.com were contributed to Capital.com, Inc., a newly formed entity, and the site was renamed Capital.com. The total cost of the assets contributed to Capital.com by the Company was $1,492. During December 1999, a subsidiary of First Union Corporation ("First Union") invested $15,000 in Capital.com in exchange for a 15% common equity stake and warrants to acquire up to an additional 5% of the common equity at a nominal price. The warrants were fully vested as of December 31, 2000. The unrealized loss of $71,008 unrealized loss in 2000 was recorded to reverse an unrealized gain of $71,008 recorded in the fiscal year ended December 31, 1999.

        In considering the appropriate valuation of this investment at December 31, 2001 and December 31, 2000, in addition to the value implied by First Union's investment for a 15% equity interest, the Board of Directors considered several factors including:

•

The valuation of comparable public company entities;



•

The very early development stage of Capital.com;



•

An estimated value for the warrants issued to First Union and the uncertainty of a subsequent valuation of Capital.com affecting the number of shares for which such warrants could be exercised;



•

The valuation implied by comparable private company transactions.

        Based on all these factors and others that were considered, the Board of Directors valued the investment in Capital.com at $700 at December 31, 2001.

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Financial Condition, Liquidity, and Capital Resources

        At December 31, 2002, the Company had $13,080 in cash and cash equivalents and $28,134 of restricted cash included in other assets on the consolidated balance sheets. In addition, the Company had outstanding debt secured by assets of the Company of $255,793 under a revolving debt funding facility and $364,171 under three asset securitizations. During the year ended December 31, 2002, the Company principally funded investments using draws on the revolving debt funding facility, proceeds from asset securitizations and equity offerings.

        As a RIC, the Company is required to distribute annually 90% or more of its investment company taxable income and 98% of its net realized short-term capital gains to shareholders. The Company provides shareholders with the option of reinvesting their distributions in the Company. In 2002, 2001 and 2000, shareholders reinvested $961, $1,048 and $742, respectively, in dividends. Since the IPO, shareholders have reinvested $3,572 of dividends in the Company. While the Company will continue to provide shareholders with the option of reinvesting their distributions in the Company, the Company has historically and anticipates having to issue debt or equity securities in addition to the above borrowings to expand its investments in middle market companies. The terms of the future debt and equity issuances cannot be determined and there can be no assurances that the debt or equity markets will be available to the Company on terms it deems favorable. The Company expects to have to raise between $450,000 and $550,000 in debt or equity capital during the year ended December 31, 2003 to fund its new investments for 2003.

Equity Capital Raising Activities

        On May 29, 2002, the Company filed a shelf registration statement (the "Shelf Registration Statement") and amended Shelf Registration Statement on July 30, 2002 with the United States Securities and Exchange Commission ("SEC"), with respect to the Company's debt and equity securities. The Shelf Registration Statement allows the Company to sell its registered debt or equity securities on a delayed or continuous basis in an amount up to $750,000. As of the date of the filing of this annual report on Form 10-K, the Company has a remaining capacity under the Shelf Registration Statement of $380,984.

        On March 26, 2003, the Company completed a public offering of its common stock and will receive net proceeds of approximately $124,657 on or about March 31, 2003 in exchange for 5,800 common shares. As part of the offering, the Company granted the underwriters a 30-day over-allotment option to purchase up to an additional 870 common shares.

        On January 8, 2003, the Company completed a public offering of its common stock and received net proceeds of approximately $88,724 in exchange for 4,100 common shares. On January 13, 2003, the Company sold 615 shares of its common stock pursuant to the underwriter's over-allotment option granted on January 8, 2003, and received net proceeds of approximately $13,309. The proceeds from the offerings were used to repay borrowings outstanding under its revolving debt funding facility.

        On November 13, 2002, the Company completed a public offering of its common stock and received net proceeds of approximately $44,507 in exchange for 2,600 common shares. On December 5, 2002, the Company sold 390 shares of its common stock pursuant to the underwriter's over-allotment option granted on November 13, 2002, and received net proceeds of approximately $6,676. The proceeds from the offerings were used to repay borrowings outstanding under its revolving debt funding facility.

        On July 15, 2002, the Company completed a public offering of its common stock and received net proceeds of approximately $73,084 in exchange for 2,900 common shares. The proceeds from the offerings were used to repay borrowings outstanding under its revolving debt funding facility.

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        On December 19, 2001, the Company completed a public offering of its common stock and received net proceeds of approximately $44,800 in exchange for 1,700 common shares. On December 31, 2001, the Company sold 255 shares of its common stock pursuant to the underwriter's over-allotment option granted on December 19, 2001, and received net proceeds of approximately $6,700. The proceeds from the offerings were used to repay borrowings outstanding under its revolving debt funding facility.

        On September 12, 2001, the Company completed a public offering of its common stock and received net proceeds of approximately $49,500 in exchange for 1,800 common shares. The proceeds from the offering were used to repay borrowings outstanding under its revolving debt funding facility.

        On June 26, 2001, the Company completed a public offering of its common stock and received net proceeds of approximately $109,100 in exchange for 4,500 common shares. On June 29, 2001, the Company sold 675 shares of its common stock pursuant to the underwriter's over-allotment option granted on June 26, 2001, and received net proceeds of approximately $16,400. The proceeds from the offerings were used to repay borrowings outstanding under its revolving debt funding facility.

Debt Capital Raising Activities

        As of December 31, 2002 and 2001, the Company, through ACS Funding Trust I ("Trust I"), an affiliated business trust, had $255,793 and $147,646, respectively, in borrowings outstanding under a revolving debt-funding facility. On December 30, 2002, the Company received a temporary increase in the aggregate commitment of the revolving debt-funding facility from $225,000 to $275,000. On February 1, 2003, the commitment reverted back to $225,000. On March 25, 2003, the facility was amended to increase the aggregate commitment back to $275,000 through the term date of the facility of May 15, 2003. As of December 31, 2002, the facility was collateralized by $467,012 of the Company's loans. The full amount of principal will be amortized over a 24-month period at the end of the term and interest is payable monthly. Interest on borrowings under this facility is charged at one month LIBOR (1.38% at December 31, 2002) plus 125 basis points. During the years ended December 31, 2002 and 2001, the Company had weighted average outstanding borrowings under this facility of $155,400 and $66,600, respectively.

        On August 8, 2002, the Company completed a $157,900 asset securitization. In connection with the transaction, the Company established ACAS Business Loan Trust 2002-2 ("Trust IV"), an affiliated business trust, and contributed to Trust IV $210,500 in loans. Subject to continuing compliance with certain conditions, the Company will remain servicer of the loans. Simultaneously with the initial contribution, Trust IV was authorized to issue $105,300 Class A notes and $52,600 Class B notes to institutional investors and $52,600 of Class C notes were retained by an affiliate of Trust IV. The Class A notes carry an interest rate of one-month LIBOR plus 50 basis points, the Class B notes carry an interest rate of one-month LIBOR plus 160 basis points. As of December 31, 2002, the Company had issued all of the Class A and Class B notes. The notes are secured by loans from the Company's portfolio companies that total $207,192 at December 31, 2002. The Class A notes mature on July 20, 2006 and the Class B notes mature on January 20, 2008. Early repayments are first applied to the Class A notes, and then to the Class B notes. During the year ended December 31, 2002, the weighted average outstanding balance of the Class A and B notes was $58,400. At December 31, 2002, total borrowings outstanding under the asset securitization were $154,145, net of a discount of $422.

        On March 15, 2002, the Company completed a $147,300 asset securitization. In connection with the transaction, the Company established ACAS Business Loan Trust 2002-1 ("Trust III"), an affiliated business trust, and contributed to Trust III $196,300 in loans. Subject to continuing compliance with certain conditions, the Company will remain servicer of the loans. Simultaneously with the initial contribution, Trust III was authorized to issue $98,200 Class A notes and $49,100 Class B notes to institutional investors and $49,100 of Class C notes were retained by an affiliate of Trust III. The

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Class A notes carry an interest rate of one-month LIBOR plus 50 basis points, the Class B notes carry an interest rate of one-month LIBOR plus 150 basis points. As of December 31, 2002, the Company had issued all of the Class A and Class B notes. The notes are secured by loans from the Company's portfolio companies that total $166,359 at December 31, 2002. The Class A notes mature on November 20, 2005 and the Class B notes mature on March 20, 2007. Early repayments are first applied to the Class A notes, and then to the Class B notes. During the year ended December 31, 2002, the weighted average outstanding balance of the Class A and B notes was $105,000. At December 31, 2002, total borrowings outstanding under the asset securitization were $117,259.

        On December 20, 2000, the Company completed a $115,400 asset securitization. In conjunction with the transaction, the Company established ACAS Business Loan Trust 2000-1 ("Trust II"), an affiliated business trust, and contributed to Trust II $153,700 in loans. Subject to certain conditions precedent, the Company will remain servicer of the loans. Simultaneously with the initial contribution, Trust II was authorized to issue $69,200 Class A notes and $46,200 Class B notes to institutional investors and $38,300 of Class C notes were retained by an affiliate of Trust II. The Class A notes carry an interest rate of one-month LIBOR plus 45 basis points, the Class B notes carry an interest rate of one-month LIBOR plus 150 basis points. As of December 31, 2000, Trust II had issued all $69,200 of Class A notes, and $18,000 of Class B notes; in January 2001, Trust II issued the remaining $28,200 of the Class B notes. The notes are secured by loans from the Company's portfolio companies that total $131,233 at December 31, 2002. The Class A notes mature on March 20, 2006, and the Class B notes mature on August 20, 2007. Early repayments are first applied to the Class A notes, and then to the Class B notes. During the years ended December 31, 2002 and 2001, the weighted average outstanding balance of the Class A and B notes was $98,000 and $109,000, respectively. At December 31, 2002 and 2001 total borrowings outstanding under the asset securitization was $92,767 and $103,495, respectively.

        The weighted average interest rates on all of the Company's borrowings, including amortization of deferred finance costs, for the years ended December 31, 2002, 2001, and 2000 were 3.43%, 5.88%, and 9.93% respectively.

        As a BDC, the Company's asset coverage must be at least 200% after each issuance of Senior Securities. As of December 31, 2002 and 2001, the Company's asset coverage was approximately 213% and 360%, respectively.

        A summary of the Company's contractual payment obligations as of December 31, 2002 are as follows:

Off Balance Sheet Arrangements

        At December 31, 2002, the Company had commitments under loan agreements to fund up to $31,510 to ten portfolio companies. These commitments are composed of working capital credit facilities and acquisition credit facilities. The commitments are subject to the borrowers meeting certain criteria. The terms of the borrowings subject to commitment are comparable to the terms of other debt securities in the Company's portfolio.

        As of December 31, 2002, the Company had debt guarantees that total $11,185 for two portfolio companies, which expire through April 2003 of which $6,185 for one portfolio company expired on

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February 7, 2003. As of December 31, 2002 the Company also had provided performance guarantees that total $13,100 for two portfolio companies that will expire upon the performance of the portfolio company. The Company generally entered into the performance guarantees to ensure a portfolio company's specific performance under a service contract as required by the respective portfolio company's customer. The Company would be required to perform under the guarantee if the related portfolio company were unable to meet specific requirements under the related contract. Any fundings under the guarantees by the Company would constitute a subordinated debt liability of the portfolio company.

        The Company has non-cancelable operating leases for office space and office equipment. The leases expire over the next eight years and contain provisions for certain annual rental escalations.

        A summary of the Company's guarantees and loan commitments as of December 31, 2002 are as follows:

Portfolio Credit Quality

Loan Grading and Performance

        The Company grades all loans on a scale of 1 to 4. This system is intended to reflect the performance of the borrower's business, the collateral coverage of the loans and other factors considered relevant.

        Under this system, loans with a grade of 4 involve the least amount of risk in the Company's portfolio. The borrower is performing above expectations and the trends and risk factors are generally favorable. Loans graded 3 involve a level of risk that is similar to the risk at the time of origination. The borrower is performing as expected and the risk factors are neutral to favorable. All new loans are initially graded 3. Loans graded 2 involve a borrower performing below expectations and indicates that the loan's risk has increased since origination. The borrower may be out of compliance with debt covenants, however, loan payments are generally not more than 120 days past due. For loans graded 2, the Company's management will increase procedures to monitor the borrower and the fair value generally will be lowered. A loan grade of 1 indicates that the borrower is performing materially below expectations and that the loan risk has substantially increased since origination. Some or all of the debt covenants are out of compliance and payments are delinquent. Loans graded 1 are not anticipated to be repaid in full and the Company will reduce the fair value of the loan to the amount it anticipates will be recovered.

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        To monitor and manage the investment portfolio risk, management tracks the weighted average investment grade. The weighted average investment grade was 3.0 and 2.9 as of December 31, 2002, and 2001, respectively. At December 31, 2002 and 2001, the Company's investment portfolio was graded as follows:

        The amounts at December 31, 2002, and 2001 do not include the Company's investments in Capital.com, Baran Group, Ltd. (formerly o2wireless Solutions, Inc.), Aerus, LLC, Westwind Group Holdings, Inc. and Gladstone Capital Corporation for which the Company has only invested in the equity securities of these companies.

        The improvement in the investment grade 4 at December 31, 2002 as compared to December 31, 2001 was principally due to strong performance at certain portfolio companies resulting in a net increase of six portfolio companies with an investment grade of 4. The improvement in the investment grade 3 as compared to December 31, 2001 is primarily the result of new investments made during the year ended December 31, 2002, which had a fair value of $442,176 as of December 31, 2002, as well as the steady performance of certain existing portfolio companies. The improvement in the investment grade 2 as compared to December 31, 2001 is partially due to the exits of certain portfolio companies during the year ended December 31, 2002 that were classified as an investment grade 2 at December 31, 2001 as well as the reduction in the fair value of certain investment grade 2 portfolio companies due to unrealized depreciation recorded during the year ended December 31, 2002. The improvement of the investment grade 2 was also attributable to the change in grades of certain portfolio companies to either grade 1 or grade 3 as a result of the underlying performance of the companies. The increase in investment grade 1 as compared to December 31, 2001 is primarily due the deterioration in performance of certain portfolio companies resulting in a net increase of four portfolio companies with an investment grade of 1.

        The Company stops accruing interest on its investments when it is determined that interest is no longer collectible. The Company's valuation analysis serves as a critical piece of data in this determination. A significant change in the portfolio company valuation assigned by the Company could have an effect on the amount of Company's loans on non-accrual status. At December 31, 2002, eleven loans to eight portfolio companies with a face amount of $73,155 were on non-accrual. Two of the eleven loans are grade 2 loans, and nine of the loans are grade 1 loans. Six of these loans totaling $48,686 with PIK interest features were on non-accrual. At December 31, 2001, four loans with a face amount of $49,900 were on non-accrual. Three of the four loans are grade 2 loans, and one of the loans is a grade 1 loan. Two of these loans totaling $9,900 with PIK interest features were on non-accrual.

        During 2002, the Company recapitalized four portfolio companies by exchanging senior and subordinated debt for preferred stock. The Company exchanged $7,200 of subordinated debt of Confluence Holdings Corp., $16,452 of senior debt of Chance Coach, Inc. ("Chance Coach"), $3,763 of senior debt of Fulton Bellows & Components, Inc., and $9,357 of senior and subordinated debt of the Inca Group for preferred stock.

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        During 2001, the Company recapitalized two portfolio companies by exchanging subordinated debt for preferred stock. $4,600 of subordinated debt in Chance Coach and $5,600 of subordinated debt in EuroCaribe Packing Company, Inc. was exchanged to preferred stock of the same face amount in each entity, respectively.

        At December 31, 2002, and 2001, loans past due were as follows:

        Of the loans greater than 90 days past due, loans totaling $27,227 were on non-accrual as of December 31, 2002, and loans totaling $10,000 were on non-accrual as of December 31, 2001. Of the remaining loans greater than 90 days past due, the loans have not been impaired as determined by the portfolio company valuation, and the Company believes that debt service collection is probable.

Credit Statistics

        The Company monitors several key credit statistics that provide information about credit quality and portfolio performance. These key statistics include:

•

Debt to EBITDA Ratio—the sum of all debt with equal or senior security rights to the Company's debt investments divided by the total adjusted earnings before interest, taxes, depreciation and amortization ("EBITDA") of the most recent twelve months or, when appropriate, the forecasted twelve months.



•

Interest Coverage Ratio—EBITDA divided by the total scheduled cash interest payments required to have been made by the portfolio company during the most recent twelve-month period.



•

Debt Service Coverage Ratio—EBITDA divided by the total scheduled principal amortization and the total scheduled cash interest payments required to have been made during the most recent twelve-month period.

        The Company requires portfolio companies to provide annual audited and monthly unaudited financial statements. Using these statements, the Company calculates the statistics described above. Buyout and mezzanine funds typically adjust EBITDA due to the nature of change of control transactions. Such adjustments are intended to normalize and restate EBITDA to reflect the proforma results of a company in a change of control transaction. For purposes of analyzing the financial performance of the portfolio companies, the Company makes certain adjustments to EBITDA to reflect the proforma results of a company consistent with a change of control transaction. The Company evaluates portfolio companies using an adjusted EBITDA measurement. Adjustments to EBITDA may include anticipated cost savings resulting from a merger or restructuring, costs related to new product development, compensation to previous owners, non-recurring revenues or expenses, and other acquisition or restructuring related items.

        The statistics are weighted by the Company's investment value for each portfolio company and do not include investments in which the Company holds only equity securities. The following charts show

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the weighted average Debt to EBITDA, Interest Coverage and Total Debt Service Coverage for the aggregate investment portfolio as of the years ended December 31, 2002, 2001, 2000, 1999, and 1998.

In addition to these statistics, the Company tracks its portfolio investments on a static-pool basis. A static pool consists of the investments made during a given year ended. The Pre-1999 static pool consists of the investments made from the time of the Company's IPO through the year ended December 31, 1998. The following table contains a summary of portfolio statistics as of the year ended December 31, 2002:

*

These amounts do not include investments in which the Company owns only equity.

**

Includes the Company's equity investments in Aerus, LLC and Baran Group, Ltd (formerly o2wireless Solutions, Inc.)

***

As a percentage of the Company's total debt investments.

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        The following charts show the weighted average Debt to EBITDA, Interest Coverage and Total Debt Service Coverage for the Company's Pre-1999 Static Pool as of the years ended December 31, 2002, 2001, 2000, 1999, and 1998:

        The following charts show the weighted average Debt to EBITDA, Interest Coverage and Total Debt Service Coverage for the Company's 1999 Static Pool as of the years ended December 31, 2002, 2001, 2000, and 1999:

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        The following charts show the weighted average Debt to EBITDA, Interest Coverage and Total Debt Service Coverage for the Company's 2000 Static Pool as of the years ended December 31, 2002, 2001 and 2000:

        The following charts show the weighted average Debt to EBITDA, Interest Coverage and Total Debt Service Coverage for the Company's 2001 Static Pool as of the years ended December 31, 2002 and December 31, 2001:

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        The following charts show the weighted average Debt to EBITDA, Interest Coverage and Total Debt Service Coverage for the Company's 2002 Static Pool as of the year ended December 31, 2002:

Impact of Inflation

        Management believes that inflation can influence the value of the Company's investments through the impact it may have on interest rates, the capital markets, the valuations of business enterprises and the relationship of the valuations to underlying earnings.

Interest Rate Risk

        Because the Company funds a portion of its investments with borrowings under its revolving debt funding facility and asset securitizations, the Company's net operating income is affected by the spread between the rate at which it invests and the rate at which it borrows. The Company attempts to match-fund its liabilities and assets by financing floating rate assets with floating rate liabilities and fixed rate assets with fixed rate liabilities or equity. The Company enters into interest rate basis swap agreements to match the interest rate basis of its assets and liabilities, thereby locking in the spread between its asset yield and the cost of its borrowings, and to fulfill its obligations under the terms of its revolving debt funding facility and term securitizations.

        As a result of the Company's use of interest rate swaps, at December 31, 2002, approximately 30% of the Company's interest bearing assets provided fixed rate returns and approximately 70% of the Company's interest bearing assets provided floating rate returns. Adjusted for the effect of interest rate swaps, at December 31, 2002, the Company had floating rate investments, tied to one-month LIBOR or the prime lending rate, in debt securities with a face amount of $799 million and had total borrowings outstanding of $620 million. All of the Company's outstanding debt at December 31, 2002 has a variable rate of interest based on one-month LIBOR. Assuming no changes to the Company's consolidated balance sheet at December 31, 2002, a hypothetical increase in one-month LIBOR by 100 basis points would increase net operating income by $1,795, or 2%, over the next twelve months compared to 2002 net operating income. A hypothetical 100 basis point decrease in one-month LIBOR would decrease net operating income $1,795, or 2%, over the next twelve months compared to 2002 net operating income.

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        At December 31, 2002, the Company had entered into 30 interest rate basis swap agreements with two large commercial banks with debt ratings of A1 under which the Company either pays a floating rate based on the prime rate and receives a floating interest rate based on one-month LIBOR, or pays a fixed rate and receives a floating interest rate based on one-month LIBOR. For those investments contributed to the term securitizations, the interest swaps enable the Company to lock in the spread between the asset yield on the investments and the cost of the borrowings under the term securitizations. The excess of payments made to swap counter parties over payments received from swap counter parties is recorded as a reduction of interest income. One-month LIBOR decreased from 1.88% at December 31, 2001 to 1.38% at December 31, 2002, and the prime rate decreased from 4.75% at December 31, 2001 to 4.25% at December 31, 2002.

        At December 31, 2002, the total notional amount of the swap agreements was $655,429 and the agreements have a remaining term of approximately 5.8 years. The following table presents the notional principal amounts of interest rate swaps by class:

(1)

Weighted average.

Item 7a Qualitative and Quantitative Disclosures About Market Risk

        The Company considers its principal market risks to be the fluctuations of interest rates and the valuations of the investment portfolio.

Interest Rate Risk

        See discussion of interest rate risk above.

Portfolio Valuation

        Investments are carried at fair value, as determined by the Board of Directors. Securities that are publicly traded are valued at the closing price on the valuation date. Debt and equity securities that are not publicly traded, or that the Company is restricted from trading, are valued at fair value as determined in good faith by the Board of Directors. In making such determination, the Board of Directors will value non-convertible debt securities at cost plus amortized OID, if any, unless adverse factors lead to a determination of a lesser valuation. In valuing convertible debt, equity or other securities, the Board of Directors determines the fair value based on the collateral, the issuer's ability to make payments, the current and forecasted earnings of the issuer, sales to third parties of similar securities, the comparison to publicly traded securities and other pertinent factors. Due to the uncertainty inherent in the valuation process, such estimates of fair value may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. Additionally, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.

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Item 8. Financial Statements and Supplementary Data

Report of Independent Auditors

Board of Directors
American Capital Strategies, Ltd.

We have audited the accompanying consolidated balance sheets of American Capital Strategies, Ltd., including the consolidated schedules of investments, as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2002, and the consolidated financial highlights for each of the five years in the period then ended. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements, the financial highlights and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements, financial highlights and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the consolidated financial position of American Capital Strategies, Ltd. at December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, and its consolidated financial highlights for each of the five years in the period then ended, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

/s/ Ernst & Young LLP

McLean, Virginia
February 11, 2003

Except for Note 16, as to which the
    date is March 27, 2003

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AMERICAN CAPITAL STRATEGIES, LTD.
CONSOLIDATED BALANCE SHEETS
(In thousands)

See accompanying notes.

34

AMERICAN CAPITAL STRATEGIES, LTD.

CONSOLIDATED SCHEDULE OF INVESTMENTS

December 31, 2002
(In thousands)