Back to GetFilings.com

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2003

OR

Commission file number 814-00149

AMERICAN CAPITAL STRATEGIES, LTD.

2 Bethesda Metro Center

14th 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 x.        No ¨.

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.    ¨

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

As of June 30, 2003, the aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant was approximately $1,340,796,000 based upon a closing price of the Registrant’s common stock of $25.02 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 25, 2004, there were 66,807,062 shares of the Registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE. The Registrant’s definitive proxy statement for the Annual Meeting of Stockholders to be held on April 29, 2004 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

General

American Capital Strategies, Ltd. (which is referred throughout this report as “American Capital”, “we” and “us”) is a publicly traded buyout and mezzanine fund that provides investment capital to middle market companies. We invest in senior and mezzanine (subordinated) debt and equity of companies in need of capital for buyouts, growth, acquisitions and recapitalizations. Our ability to fund the entire capital structure is an advantage in completing many middle market transactions. Our wholly-owned operating subsidiary, American Capital Financial Services, Inc., or ACFS, provides financial advisory services to our portfolio companies. We invested on average $33 million in 2003 in each new portfolio company. We generally have not invested more than 5% of our equity capital in one transaction. Our largest investment to date has been $70 million. ACFS arranges and secures capital for large transactions, particularly buyouts that we sponsor.

Our primary business objectives are to increase our taxable income, net operating income and net asset value by investing in senior debt, subordinated debt and equity of middle market companies with attractive current yields and potential for equity appreciation and realized gains. We are an investor in and sponsor of management and employee buyouts, invest in private equity sponsored buyouts, and provide capital directly to private and small public companies. Historically a majority of our financings have been to assist in the funding of change of control management buyouts, and we expect that trend to continue. Capital that we provide directly to private and small public companies is used for growth, acquisitions or recapitalizations.

We are a Delaware corporation, which was incorporated in 1986. On August 29, 1997, we completed an initial public offering, or IPO, of our common stock and became a non-diversified, closed end investment company, which has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended. On October 1, 1997, we began operations so as to qualify to be taxed as a regulated investment company, or RIC, as defined in Subtitle A, Chapter 1, under Subchapter M of the Internal Revenue Code of 1986, as amended. As a regulated investment company, we are not subject to federal income tax on the portion of our taxable income and capital gains we distribute to our stockholders.

Our loans typically range from $5 million to $50 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. We price our debt and equity investments based on our analysis of each transaction. As of December 31, 2003, the weighted average effective interest rate on our debt securities was 13.4%. From our IPO in 1997, through December 31, 2003, we invested over $486 million in equity securities and over $2.1 billion in debt securities of middle market companies, including approximately $71 million in funds committed but undrawn under credit facilities. We are prepared to be a long-term partner to our portfolio companies, thereby positioning us to participate in their future financing needs. As of December 31, 2003, we have invested $494 million in follow-on investments to fund growth, acquisitions or working capital (sometimes in distress situations).

We generally acquire equity interests in the companies from which we have purchased debt securities with the goal of enhancing our overall return. As of December 31, 2003, we had a fully-diluted weighted average ownership interest of 46% in our portfolio companies. In most cases, we receive rights to require the portfolio company to purchase the warrants and stock held by us, known as put rights, under various circumstances including, typically, the repayment of our loans or debt securities. We may use our put rights to dispose of our equity interest in a business, although our ability to exercise our put rights may be limited or nonexistent if a business is illiquid. In most cases where we invest equity, we receive the right to representation on our portfolio company’s board of directors.

2

The debt structures of our portfolio companies generally provide for scheduled amortization of senior debt, including our senior debt investments, which also helps improve our subordinated debt investments within the portfolio company’s capital structure. The opportunity to liquidate our investments may occur if a portfolio company refinances our loans, is sold in a change of control transaction or sells its equity in a public offering or if we exercise our put rights. We generally do not have the right to require that a portfolio company undergo an initial public offering by registering securities under the Securities Act of 1933, as amended, but we generally do have the right to sell our equity interests in a public offering by a portfolio company to the extent permitted by the underwriters.

Since our IPO in 1997, through December 31, 2003, we have realized $72 million in gross realized gains and $57 million in gross realized losses resulting in $15 million in cumulative net gains. We have exited 55 investments, or $589 million of our originally invested capital, representing 22% of our total capital invested since our IPO earning a 19% compounded annual return on these investments from the interest, dividends, fees, gains and losses over the life of the investments.

We make available significant managerial assistance to our portfolio companies. Such assistance typically involves closely monitoring the operations of the company, advising the portfolio company’s board on matters such as the business plan and the hiring and termination of senior management, providing financial guidance and participating on the company’s board of directors. At December 31, 2003, we had board seats at 62 out of 86 portfolio companies and had board observation rights on 16 of our remaining portfolio companies. We also have an operations team, including three ex-CEOs with significant turnaround and bankruptcy experience, that provides intensive operational and managerial assistance. Providing assistance to our portfolio companies serves as an opportunity for us to maximize their value.

We have established an extensive referral network comprised of investment bankers, private equity and mezzanine funds, commercial bankers and business and financial brokers. We have a marketing department dedicated to maintaining contact with members of the referral network and receiving opportunities for us to consider. In 2003, our marketing department developed an extensive proprietary database of reported middle market transactions. Based on the data we have gathered, we believe that we are the leader in the market with the industry still very fragmented with most firms only completing one or two transactions during 2003. During 2003, our marketing department received information concerning several thousand transactions for consideration. Most of those transactions did not meet our criteria for initial consideration, but the opportunities that met those criteria were sent to our principals for further review and consideration. We have also developed an internet website that provides businesses an efficient tool for learning about American Capital and our capabilities.

Corporate Information

Our executive offices are located at 2 Bethesda Metro Center, 14^th Floor, Bethesda, Maryland 20814 and our telephone number is (301) 951-6122. In addition to our executive offices, we maintain offices in New York, San Francisco, Los Angeles, Philadelphia, Chicago and Dallas.

Our corporate website is located at www.AmericanCapital.com. We make available free of charge on our website our 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.

3

Lending and Investment Decision Criteria

We review certain criteria in order to make investment decisions. The list below represents a general overview of the criteria we use in making our lending and investment decisions. Not all criteria are required to be favorable in order for us to make an investment. Follow-on investments for growth, acquisitions or recapitalizations are based on the same general criteria. Follow-on investments in distress situations are based on the same general criteria but are also evaluated on the potential to preserve prior investments.

Operating History. We generally focus on companies that have been in business over 10 years and have an attractive operating history, including generating positive cash flow. We generally target companies with significant market share in their products or services relative to their competitors. In addition, we consider factors such as customer concentration, performance during recessionary periods, competitive environment and ability to sustain margins. As of December 31, 2003, our current portfolio companies had an average age of 35 years with 2003 average sales of $93 million and 2003 average adjusted earnings before interest, taxes, depreciation and amortization, or EBITDA, of $14 million.

Growth. We consider 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 us.

Liquidation Value of Assets. Although we do not operate as an asset-based lender, liquidation value of the assets collateralizing our loans is a 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 brand recognition, market reputation, customer lists, networks, databases and recurring revenue streams.

Experienced Management Team. We consider the quality of senior management to be extremely important to the long term performance of most companies. Therefore, we consider it important that senior management be experienced and properly incentivized through significant ownership interest in the company.

Exit Strategy. We consider it important that a prospective portfolio company, over time, have at least one or several ways in which our financing can be repaid and our equity interest purchased.

Investment Portfolio

We generally invest in domestic privately-held middle market companies; however, we will occasionally make investments in portfolio companies that have securities registered under the Securities Act of 1933, as amended, or in securities of foreign issuers. Also, an existing portfolio company may undergo a public offering and register its securities under the Securities Act of 1933, as amended, subsequent to our initial investment. We also maintain a diversified investment portfolio investing in a broad range of industries. As of December 31, 2003, our largest concentration of investments in one industry segment was less than 13% of the total fair value of our investments. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Critical Accounting Policies” for a discussion on how we determine the fair value of our investments.

4

Summaries of our portfolio of securities as of December 31, 2003 and 2002 at cost and fair value are shown in the following table:

We use the Global Industry Classification Standards for classifying the industry groupings of our portfolio companies. The following table shows the portfolio composition by industry grouping at cost and at fair value:

5

The following table shows our portfolio composition by geographic location at cost and at fair value. The geographic composition is determined by the location of the corporate headquarters of the portfolio company.

6

Operations

Marketing, Origination and Approval Process. To source buyout and financing opportunities, we have a dedicated marketing department that targets an extensive referral network comprised of investment banks, private equity and mezzanine funds, commercial banks, and business and financial brokers. Our marketing department developed and maintains an extensive proprietary database of reported middle market transactions that enables us to monitor and evaluate the middle market investing environment. Our financial professionals review thousands of financing memorandums and private placement memorandums sourced from this extensive referral network in search of potential buyout or financing opportunities. Those that pass an initial screen are then evaluated over many months by a team led by one of our 16 financial principals. The financial principal and his or her team, with the assistance from our Financial Accounting and Compliance Team (FACT) and our operations team, along with the oversight of our investment committee, are responsible for structuring, negotiating, pricing and closing the transaction.

As of December 31, 2003, our 16 financial principals had a staff of 51 investment professionals, our investment team. They are supported by FACT, our team of 17 CPAs and accounting professionals, who assist in initial accounting due diligence of prospective portfolio companies, portfolio monitoring and quarterly valuations of our portfolio assets. In addition, the financial principals are supported by our 10-member operations team (including two financial principals), who assist in initial operational due diligence and providing managerial assistance to portfolio companies, particularly those that are underperforming. These professionals conduct extensive due diligence of each target company that passes the initial screening process. This includes one or more on-site visits, a review of the target company’s historical and prospective financial information, identifying pro-forma adjustments, interviews with management, employees, customers and vendors, review of the adequacy of the target company’s systems, background investigations of senior management and research on the target company’s products, services and industry. We often engage professionals such as environmental consulting firms, accounting firms, law firms, risk management companies and management consulting firms with relevant industry expertise to perform elements of the due diligence.

Upon completion of our due diligence, our investment team, FACT, our operations team as well as any consulting firms prepare and present an extensive investment committee report containing the due diligence information to the investment committee. Our investment committee is comprised of our six executive officers, including our chief executive officer, chief operating officer and chief financial officer. Our policy calls for the investment committee to approve each financing and our board of directors to approve each financing in excess of $1 million.

Portfolio Management. In addition to the extensive due diligence at the time of the original investment decision, we seek to preserve and enhance the performance of our portfolio companies through our active involvement with our portfolio companies. This generally includes attendance at portfolio company board meetings, management consultation and monitoring of covenant compliance. Our investment team and FACT regularly review portfolio company monthly financial statements to assess performance and trends, periodically conduct on-site financial and operational reviews and evaluate industry and economic issues that may affect the portfolio company. FACT, with the assistance of our investment team, subject to the oversight of our investment committee and our audit committee, prepares a quarterly valuation of each of our portfolio company investments. We have engaged the independent financial advisory firm of Houlihan Lokey Howard & Zukin Financial Advisory, Inc. to assist in this process by reviewing each quarter a selection of our portfolio companies and to report their conclusions to our audit committee.

Operations Team. The operations team is led by a financial principal and composed of seasoned ex-senior managers with extensive operational experience and accounting and financial professionals that generally work with our portfolio companies that are under performing. Portfolio companies that are performing below plan generally require more extensive assistance with enhancing their business plans, marketing strategies, product positioning, evaluating cost structures and recruiting management personnel. The operations team works closely with the portfolio company and, in many instances, members of the operations team will assist the portfolio company with day-to-day operations.

7

Loan Grading

We evaluate and classify all loans based on their current risk profiles. During the valuation process each quarter, a loan grade of 1 to 4 is assigned to each loan. 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 our investment committee. 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 our loan grading practices, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Portfolio Credit Quality.”

Competition

We compete with a large number of private equity and mezzanine funds and other financing sources, including traditional financial services companies such as finance companies and commercial banks. Some of our competitors are substantially larger and have considerably greater financial resources than we do. Our competitors may have a lower cost of funds and many have access to funding sources that are not available to us. In addition, certain of our 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 we face will not have a material adverse effect on our business, financial condition and results of operations. In addition, because of this competition, we may not be able to take advantage of attractive investment opportunities from time to time and there can be no assurance that we will be able to identify and make investments that satisfy our investment objectives or that we will be able to meet our investment goals.

Employees

As of December 31, 2003, we had 132 employees, including 67 investment professionals, 17 accounting professionals involved in evaluating prospective investments and monitoring portfolio companies, 22 corporate finance and accounting professionals, 2 legal professionals, 7 information technology professionals, and 17 administrative staff personnel. We believe that our relations with our employees are excellent.

Business Development Company Requirements

Qualifying Assets

As a business development company, we may not acquire any asset other than qualifying assets, as defined by the 1940 Act, unless, at the time the acquisition is made, the value of our qualifying assets represent at least 70% of the value of our total assets. The principal categories of qualifying assets relevant to our business are the following:

8

We may not change the nature of our business so as to cease to be, or withdraw our election as, a business development company unless authorized by vote of the holders of the majority, as defined in the 1940 Act, of our outstanding voting securities.

Since we made our business development company election, we have not made any substantial change in our structure or in the nature of our business.

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

Temporary Investments

Pending investment in other types of qualifying assets, we have invested our 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, referred to as temporary investments, so that at least 70% of our assets are qualifying assets. Typically, we invest in U.S. Treasury bills. Additionally, we 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 our board of directors. There is no percentage restriction on the proportion of our assets that may be invested in such repurchase agreements. A repurchase agreement involves the purchase by an investor, such as us, 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. We require the continual maintenance by our 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, we 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, we have issued, and intend 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 us, as a BDC, to issue senior debt securities and preferred stock, together defined as senior securities in the 1940 Act, in amounts such that our 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, we are exposed to the risks of leverage. Although we have no current intention to do so, we have retained the right to issue preferred stock. As permitted by the 1940 Act, we may, in addition, borrow amounts up to 5% of our total assets for temporary purposes. As of December 31, 2003, our asset coverage was 240%.

Regulated Investment Company Requirements

We operate so as to qualify as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986. If we qualify as a regulated investment company and annually distribute to our stockholders in a timely manner at least 90% of our investment company taxable income, we will not be subject to federal income tax on the portion of our taxable income and capital gains we distribute to our shareholders. Taxable income generally differs from net income as defined by generally accepted accounting principles due to temporary and permanent timing differences in the recognition of income and expenses, returns of capital and net unrealized appreciation or depreciation.

9

Generally, in order to maintain our status as a regulated investment company, we must a) continue to qualify as a business development company; b) distribute to our shareholders in a timely manner, at least 90% of our investment company taxable income, as defined by the Internal Revenue Code; c) derive in each taxable year at least 90% of our gross investment company income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities or other income derived with respect to our business of investing in such stock or securities as defined by the Internal Revenue Code; and d) meet investment diversification requirements. The diversification requirements generally require us at the end of each quarter of the taxable year to have (i) at least 50% of the value of our assets consist of cash, cash items, government securities, securities of other regulated investment companies and other securities if such other securities of any one issuer do not represent more than 5% of our assets and 10% of the outstanding voting securities of the issuer and (ii) no more than 25% of the value of our assets 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 us and are engaged in the same or similar or related trades or businesses.

In addition, with respect to each calendar year, if we distribute or have treated as having distributed (including amounts retained but designated as deemed distributed) in a timely manner 98% of our capital gain net income for each one-year period ending on October 31, and distribute 98% of our investment company net ordinary income for such calendar year (as well as any ordinary income not distributed in prior years), we will not be subject to the 4% nondeductible Federal excise tax imposed with respect to certain undistributed income of regulated investment companies.

If we fail to satisfy the 90% distribution requirement or otherwise fail to qualify as a regulated investment company in any taxable year, we will be subject to tax in such year on all of our taxable income, regardless of whether we make any distribution to our stockholders. In addition, in that case, all of our distributions to our shareholders will be characterized as ordinary income (to the extent of our current and accumulated earnings and profits). We have distributed and currently intend to distribute sufficient dividends to eliminate our investment company taxable income.

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

Investment Objectives and Policies

Our primary business objectives are to increase our taxable income, net operating income and net asset value by investing in senior debt, subordinated debt and equity of middle market companies with attractive current yields and potential for equity appreciation and realized gains. The following restrictions, along with these investment objectives, are our 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 our 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 us will not require American Capital to dispose of portfolio securities or to take other action to satisfy the percentage restriction:

10

Investment Advisor

We have no investment advisor and are internally managed by our executive officers under the supervision of our board of directors.

Item 2. Properties

We do not own any real estate or other physical properties materially important to our operation. We lease office space in seven locations for terms ranging up to 10 years.

Item 3. Legal Proceedings

We are involved in routine litigation and administrative proceedings arising in the ordinary course of business. As previously reported, the staff of the Securities and Exchange Commission has requested that we voluntarily provide certain documents and information as part of an informal, non-public inquiry. The staff has not indicated the subject of the inquiry. We have complied fully with the requests and expect to continue to do so

11

should additional information be requested. In a letter to us, the SEC staff stated, “This inquiry is nonpublic and should not be construed as an indication by the Commission or its staff that any violations of law have occurred, or as an adverse reflection upon any person or security.”

In the opinion of management, the ultimate resolution of all such proceedings is not expected to have a material adverse effect on our business, financial condition, or results of operation.

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

During the fourth quarter of 2003, there were no matters submitted to a vote our security holders through the solicitation of proxies or otherwise.

12

PART II

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

Since our IPO, we have distributed, and currently intend to continue to distribute in the form of dividends, a minimum of 90% of our investment company taxable income on a quarterly basis to our shareholders. We intend to retain long-term capital gains and treat them as deemed distributions for tax purposes. We report the estimated tax characteristics of each dividend when declared, while the actual tax characteristics of dividends are reported annually to each stockholder on Form 1099DIV. For income tax purposes, all of our dividends declared through December 31, 2003 have been distributions of ordinary income for tax purposes. There is no assurance that we 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.

Our common stock is quoted on the NASDAQ Stock Market under the symbol ACAS. As of February 27, 2004, we had 582 shareholders of record. The following table sets forth the range of high and low sales prices of our common stock as reported on the NASDAQ Stock Market and our dividends declared for the period from our IPO through December 31, 2003.

13

Item 6. Selected Financial Data

AMERICAN CAPITAL STRATEGIES, LTD.

Consolidated Selected Financial Data

The selected financial data should be read in conjunction with our consolidated financial statements and notes thereto.

14

(Dollars in thousands except per share data)

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 we operate negatively impacting our financial resources; (ii) certain of our competitors have substantially greater financial resources than us reducing the number of suitable investment opportunities offered to us or reducing the yield necessary to consummate the investment; (iii) there is uncertainty regarding the value of our privately held securities that require our good faith estimate of fair value for which a change in estimate could affect our net asset value; (iv) our investments in securities of privately held companies may be illiquid which could affect our ability to realize a gain; (v) our portfolio companies could default on their loans or provide no returns on our investments which could affect our operating results; (vi) we are dependent on external financing to grow our business; (vii) our ability to retain key management personnel; (viii) an economic downturn or recession could impair our portfolio companies and therefore harm our operating results; (ix) our borrowing arrangements impose certain restrictions; (x) changes in interest rates may affect our cost of capital and net operating income; (xi) we cannot incur additional indebtedness unless we maintain an asset coverage of at least 200%, which may affect returns to our shareholders; (xii) we may fail to continue to qualify for our pass-through treatment as a regulated investment company which could have an affect on shareholder return; (xiii) our common stock price may be volatile; and (xiv) general business and economic conditions and other risk factors described in our reports filed from time to time with the Securities and Exchange Commission. We caution 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 our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto.

Portfolio Composition

American Capital is a publicly traded buyout and mezzanine fund that provides investment capital to middle market companies. We invest in senior and subordinated debt and equity of companies in need of capital for buyouts, growth, acquisitions and recapitalizations. Our ability to fund the entire capital structure is an advantage in completing many middle market transactions. Our wholly-owned operating subsidiary, American Capital Financial Services, Inc., or ACFS, provides financial advisory services to our portfolio companies. The total portfolio value of investments was $1,911,743 and $1,248,459 at December 31, 2003 and 2002, respectively. During the years ended December 31, 2003, 2002, and 2001, we made investments totaling $1,083,100, $573,500 and $389,300, including $47,600, $20,900 and $6,500 in funds committed but undrawn under credit facilities, respectively. The weighted average effective interest rate on debt securities was 13.4%, 12.5% and 13.9%, at December 31, 2003, 2002, and 2001, respectively.

American Capital is an investor in and sponsor of management and employee buyouts, invests in private equity sponsored buyouts, and provides capital directly to private and small public companies. We provide senior debt, mezzanine debt and equity to fund growth, acquisitions and recapitalizations. We also provide capital directly to private and small public companies for growth, acquisitions or recapitalizations.

We seek to be a long-term partner with our portfolio companies. As a long-term partner, we will invest capital in a portfolio company subsequent to our initial investment if we believe that it can achieve appropriate returns for our 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

15

plant expansions, or iv) working capital for portfolio companies, sometimes in distressed situations, that need capital to fund operating costs, debt service, or growth in receivables or inventory.

Our investments during the years ended December 31, 2003, 2002 and 2001 were as follows:

Critical Accounting Policies

Valuation of Investments

We value our investment portfolio each quarter. Our FACT group prepares the portfolio company valuations each quarter using the most recent portfolio company financial statements and forecasts. The FACT group will consult with the respective members of our investment team who are managing the portfolio company 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 our investment committee and audit committee of our 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 in good faith by our board of directors. Securities that are publicly traded are valued at the closing price on the valuation date. For debt and equity securities of companies that are not publicly traded, or for which we have various degrees of trading restrictions, we prepare 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, the liquidation or collateral value of the portfolio company’s assets, third party valuations of the portfolio company and the value of recent investments in the equity securities of the portfolio company. We weight some or all of the above valuation methods to determine the estimated enterprise value of the company. In valuing convertible debt, equity or other securities, we value our equity investment based on our pro rata share of the residual equity value available after deducting all outstanding debt from the estimated enterprise value. We value non-convertible debt securities at cost plus amortized original issue discount, or OID, to the extent that the estimated enterprise value of the portfolio company exceeds the outstanding debt of the portfolio company. If the estimated enterprise value is less than the outstanding debt of the company, we reduce the value of our 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.

16

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 from the valuations currently assigned.

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. The portion of the loan origination fees paid that represent additional yield or discount on 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. We stop accruing interest or dividends on our investments when it is determined that the interest or dividend is not collectible. We assess the collectibility of the interest and dividends based on many factors including the portfolio company’s ability to service our loan based on current and projected cash flows as well as the current valuation of the enterprise. For investments with payment-in-kind (PIK) interest or dividends, we base income accruals on the valuation of the PIK notes or securities received from the borrower. If the portfolio company valuation indicates a value of the PIK notes or securities that is not sufficient to cover the contractual interest or dividend, we will not accrue interest or dividend income on the notes or securities.

A change in the portfolio company valuation assigned by us could have an effect on the amount of loans on non-accrual status. Also, a change in a portfolio company’s operating performance and cash flows can impact a portfolio company’s ability to service our debt and therefore could impact our interest recognition.

Fee Income Recognition

Fees primarily include financial advisory, transaction structuring, loan financing and prepayment fees. Financial advisory fees represent amounts received for providing advice and analysis to companies and are recognized as earned provided collection is probable. Transaction structuring and loan 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 fees are recognized as they are received.

Stock-based compensation

In 2003, we adopted Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” to account for stock-based compensation plans for all stock options granted in 2003 and forward as permitted under SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—An Amendment to FASB Statement No. 123.” In applying SFAS 123 to all stock options granted in 2003 and forward, the estimated fair value of the stock options are expensed over the vesting period of the options and are included on the accompanying Consolidated Statements of Operations as “Stock-based compensation.” In accordance with SFAS 123, we elected to continue to apply the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” to all stock options granted prior to January 1, 2003 and provide pro forma disclosure of our consolidated net operating income and net increase in shareholders’ equity resulting from operations calculated as if compensation costs were computed in accordance with SFAS 123.

Results of Operations

Our consolidated financial performance, as reflected in our Consolidated Statements of Operations, is composed of three primary elements. The first element is “Net operating income,” which is primarily the interest, dividends and prepayment fees earned from investing in debt and equity securities and the fees we earn from financial advisory and transaction structuring activities, less our operating expenses. The second element is “Net unrealized (depreciation) appreciation of investments,” which is the net change in the estimated fair values of our portfolio investments at the end of the period compared with their estimated fair values at the beginning of the

17

period or their stated costs, as appropriate. The third element is “Net realized gain (loss) on investments,” which reflects the difference between the proceeds from an exit of a portfolio investment and the cost at which the investment was carried on our Consolidated Balance Sheets.

The consolidated operating results for the years ended December 31, 2003, 2002, and 2001 are as follows:

Fiscal Year 2003 Compared to Fiscal Year 2002

Operating Income

Total operating income is comprised of two components: interest and dividend income and fee income. For the year ended December 31, 2003, total operating income increased $59,258, or 40%, over the year ended December 31, 2002. Interest and dividend income consisted of the following for the years ended December 31, 2003 and December 31, 2002:

Interest income on debt securities increased by $38,300, or 30%, to $167,480 for 2003 from $129,180 for 2002, primarily due to an increase in our debt investments, which was partially offset by a decline in the daily weighted average interest rate on our debt investments, excluding the impact of interest rate swaps. Our daily weighted average debt investments at cost, excluding discounts, increased from $950,500 in 2002 to $1,316,500 in 2003 resulting from new loan originations net of loan repayments during the last twelve months ended December 31, 2003. The daily weighted average interest rate on debt investments decreased to 12.7% in 2003 from 13.6% in 2002 due partially to a decrease in the weighted average monthly prime lending rate from 4.68% in 2002 to 4.10% in 2003 and a decrease in the average monthly LIBOR rate from 1.76% in 2002 to 1.21% in 2003. The decrease in the weighted average interest rate on debt securities is also partially due to an increase in the average non-accruing loans from $66,956 in 2002 to $103,998 in 2003.

To match the interest rate basis of our assets and liabilities and to fulfill our obligations under the terms of our revolving debt funding facility and asset securitizations, we enter into interest rate swap agreements to hedge securitized debt investments in which we either pay a floating rate based on the prime rate and receive a floating rate based on LIBOR, or pay a fixed rate and receive a floating rate based on LIBOR. Use of the interest rate swaps enables us to manage the impact of changing interest rates on spreads between the yield on our investments and the cost of our borrowings. As a result, both interest income and interest expense are affected by changes in LIBOR. See “Quantitative and Qualitative Disclosure About Market Risk” for a discussion of our use

18

of interest rate swaps to mitigate the impact of interest rate changes on net operating income. The cost of the interest rate swap agreements increased by $6,061, from $11,153 for 2002 to $17,214 for 2003. The daily weighted average interest rate on debt investments at cost, including the impact of interest rate swaps, decreased to 11.4% in 2003 from 12.4% in 2002, due to the reasons noted above and the negative impact of our interest rate swaps. The quarterly average notional amount of interest rate swaps as a percentage of the daily weighted average debt investments increased from 52.3% in 2002 to 59.2% in 2003.

Dividend income on equity securities increased by $5,465 to $8,191 for 2003 from $2,726 for 2002 due primarily to cash dividends of $4,925 received from one portfolio company. Our daily weighted average total debt and equity investments at cost increased from $1,078,300 in 2002 to $1,547,800 in 2003. The daily weighted average yield on total debt and equity investments, including the impact of interest rate swaps, decreased to 10.2% in 2003 from 11.2% in 2002 primarily due to the reasons noted above.

Fee income consisted of the following for the years ended December 31, 2003 and December 31, 2002:

Fee income increased by $22,268, or 89%, to $47,222 in 2003 from $24,954 in 2002. In 2003, we recorded $14,176 in transaction structuring fees for ten buyouts and direct investment totaling $486,600 of American Capital financing. In 2002, we recorded $4,904 for ten buyouts and direct investments totaling $245,300 of American Capital financing. The transaction structuring fees were 2.9% and 2.0% of buyout and direct investments in 2003 and 2002, respectively. The increase in financing fees was attributable to an increase in new debt investments from $480,226 in 2002 to $902,631 in 2003. The financing fees were 2.1% of loan originations in 2003 and 2002. The prepayment fees of $3,836 in 2003 are the result of the prepayment by ten portfolio companies of loans totaling $136,800 compared to prepayment fees of $1,478 in 2002 as the result of the prepayment by three portfolio companies of loans totaling $42,900.

Operating Expenses

Operating expenses for 2003 increased $21,104, or 47%, over 2002. Interest expense increased from $14,321 for 2002 to $18,514 for 2003 due to an increase in our weighted average borrowings from $416,800 for 2002 to $582,200 for 2003, net of a decrease in the weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 3.43% for 2002 to 3.18% for 2003. As discussed above, the decrease in the weighted average interest rate is due to a decrease in the average monthly LIBOR rate from 1.76% in 2002 to 1.21% in 2003. Salaries and benefits expense increased from $18,621 for 2002 to $27,950 for 2003 due primarily to an increase in employees from 108 at December 31, 2002 to 132 at December 31, 2003 and annual salary rate increases. General and administrative expenses increased from $11,531 for 2002 to $16,529 for 2003 primarily due to higher facilities expenses resulting from an increase in the number of employees and additional corporate office space, accounting fees, legal fees, financial reporting expenses, reserves for uncollectible amounts, and insurance expense. Stock-based compensation was $2,584 for the year ended December 31, 2003. In 2003, we adopted SFAS 123 to account for stock-based compensation plans for all stock options granted in 2003 and forward as permitted under SFAS 148.

19

Net Realized Gains (Losses)

Our net realized gains (losses) for 2003 and 2002 consisted of the following:

During 2003, we sold all of our equity interest in Weston ACAS Holdings, Inc. consisting of common stock, common stock warrants and preferred stock for $30,950 in cash proceeds and Weston also prepaid its remaining subordinated debt of $6,500, all as part of a recapitalization of Weston that resulted in Weston employees gaining 100% ownership of the company. We recognized a realized gain of $24,930 consisting of a $22,701 gain on the sale of our equity interest and $2,229 on the realization of the unamortized OID offset by the reversal of the unrealized appreciation of $20,822. As part of the recapitalization, we provided $12,750 of new subordinated debt financing to Weston as part of a $25,000 mezzanine debt financing provided by us and another mezzanine investor. In addition, we received a prepayment fee of $615.

During 2003, we exited our investment in CPM Acquisition Corp. through a sale of our common stock warrants and the prepayment of the senior and subordinated debt. We received $30,428 in total proceeds from the sale and recognized a net realized gain of $6,099 offset by the reversal of unrealized appreciation of $3,462. The realized gain was comprised of $2,162 of unamortized OID on the senior and subordinated debt and $3,937 on the common stock warrants. The sale proceeds we recognized included proceeds held in escrow of $458, and we could receive up to an additional $342 in sale proceeds to be held in escrow over the next three years. In addition, we received a prepayment fee of $729.

20

During 2003, we exited our investment in A&M Cleaning Products, Inc. through a sale of our common stock warrants and redeemable preferred stock and the prepayment of the subordinated debt. We received $14,942 in total proceeds from the sale and recognized a net realized gain of $5,181 offset by the reversal of unrealized appreciation of $4,916. The realized gain was comprised of $653 of unamortized OID on the subordinated debt and $4,528 on the common stock warrants and redeemable preferred stock. The sale proceeds we recognized included proceeds held in escrow of $755, and we could receive up to an additional $293 in sale proceeds held in escrow over the next three years. In addition, we received a prepayment fee of $120.

During 2003, we exited our investment in CST Industries, Inc. through a sale of our common stock and the prepayment of the subordinated debt. We received $14,250 in total proceeds from the sale and recognized a net realized gain of $4,964 offset by the reversal of unrealized appreciation of $3,546. The realized gain was comprised of $804 of unamortized OID on the subordinated debt and $4,160 on the common stock. In addition, we received a prepayment fee of $270.

During 2003, we exited our investment in Tube City, Inc. through a sale of our common stock warrants and the prepayment of the subordinated debt. We received $19,328 in total proceeds from the sale and recognized a net realized gain of $3,729 offset by the reversal of unrealized appreciation of $2,525. The realized gain was comprised of $1,927 of unamortized OID on the subordinated debt and $1,802 on the common stock warrants. In addition, we received a prepayment fee of $234.

During 2003, we sold investments in three portfolio companies for a nominal sales price as part of one sale transaction. We sold our investment in the redeemable and convertible preferred stock of Fulton Bellows & Components, Inc. and recognized a realized loss of $10,911 offset by the reversal of unrealized depreciation of $10,911. We retained our common stock warrant and debt investments in Fulton Bellows. We also sold all of our investments in Parts Plus Group Inc., consisting of senior subordinated debt, redeemable preferred stock and common stock warrants, and recognized a realized loss of $5,384 offset by the reversal of unrealized depreciation of $5,380. We sold all of our investments in Westwind Group Holding, Inc., consisting of redeemable preferred stock and common stock, and recognized a realized a loss $3,598 offset by the reversal of unrealized depreciation of $3,598.

During 2003, we completed a recapitalization of Starcom Holdings, Inc. through a newly created company, NewStarcom Holdings, Inc. Under the terms of the recapitalization, we exchanged the existing senior debt of Starcom we purchased on June 30, 2003 for preferred equity in NewStarcom. In addition, American Capital’s existing subordinated notes issued by Starcom and its subsidiaries were refinanced with the proceeds of new subordinated notes issued by NewStarcom. Another existing investor in Starcom also exchanged its subordinated notes for preferred equity of NewStarcom and also provided $2,000 of new subordinated debt financing to NewStarcom. We realized a loss of $4,533 to write off our original common equity investment in Starcom as a result of the recapitalization offset by the reversal of unrealized depreciation of $4,530.

In May 1998, we made an investment of $20,000 in the New Piper Aircraft, Inc. consisting of subordinated debt and common stock warrants. On June 30, 2003, we purchased the $56,000 existing senior debt of Piper Aircraft for $33,500 and assumed an undrawn $11,500 revolving credit facility. On June 30, 2003, we entered

21

into a binding Exchange of Indebtedness Agreement, the exchange agreement, to exchange up to $22,500 of the purchased senior debt into warrants to purchase shares of Piper Aircraft common stock as part of a recapitalization of Piper Aircraft. The recapitalization contemplated by the exchange agreement required the consent of the existing Piper Aircraft stockholders. On July 17, 2003, a recapitalization transaction was consummated on terms economically similar to but structurally different from that contemplated by the exchange agreement. Under the final recapitalization, all of the existing Piper Aircraft equity, including our existing common stock warrants, was converted into cash. The purchased senior debt discount was converted into $481 of subordinated debt, with the remaining $22,019 converted into 94.0% of the common equity of Piper Aircraft. As part of the recapitalization, an existing Piper Aircraft stockholder purchased the remaining 6.0% of common equity for $851. As a result of the final recapitalization consummated in the third quarter of 2003, we recorded a realized loss of $2,231 to write off our investment in the existing equity of Piper Aircraft offset by unrealized appreciation of $2,231 for the reversal of prior period depreciation.

During 2003, we realized gains of $1,641, $782, $632, $629 and $564, respectively, from the realization of unamortized OID from the prepayment of debt by Plastech Engineered Products, Inc., Lubricating Specialties Co., MBT International, Inc., DigitalNet, Inc. and 3SI Security Systems, Inc. In addition, we received prepayment fees of $800 and $543 from Plastech and 3SI, respectively.

During 2002, we exited our investment in Middleby Corporation through a sale of our common stock warrants and the prepayment of subordinated debt. We 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, we received a prepayment fee of $1,020.

During 2002, we exited our investment in IGI, Inc. through a sale of our common stock warrants and the prepayment of subordinated debt. We 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, we received a prepayment fee of $223.

During 2002, we also recognized realized gains of $2,425 and $673, respectively, from the realization of unamortized OID on the prepayment of debt by Weston and Omnova Solutions, Inc., respectively. In addition, we received a prepayment fee of $235 related to the prepayment by Weston.

In September 2002, we exited our investment in Goldman Industrial Group 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, or BML, and the intellectual property, brand name, and other intangible assets of Bridgeport Machines, Inc. In 2000, we made a $30,000 investment consisting of subordinated debt with common stock warrants in Goldman. We 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 our carrying value to fair value. We recognized a net realized loss of $25,578 in 2002 on our investments in $25,000 of the subordinated debt and common stock warrants and recorded an unrealized gain of $25,183 to reverse the previously recorded unrealized loss. The Bridgeport assets were purchased by BPT Holdings, Inc., which was capitalized with $18,000 from us in the form of senior debt, preferred stock and common stock and the assumption of the $30,000 subordinated debt from Goldman. Of our $30,000 investment in Goldman, $5,000 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, which were deemed not to have any value and were therefore treated as a realized loss.

In May 2002, we exited our investment in Decorative Surfaces International, Inc., or DSI, through a sale of DSI’s assets under Section 363 of the Bankruptcy Code. We recognized a net realized loss of $1,353 on our investments in the subordinated debt, preferred stock, and common stock of DSI, which had a cumulative cost basis of $23,466 at March 31, 2002. The DSI assets were purchased by American Decorative Surfaces, Inc.,

22

or ADSI, which was capitalized by us through ADSI’s assumption of $24,502 of our subordinated debt investment in DSI at par and by our $13,675 cash investment in the preferred stock of ADSI.

In May 2002, we also exited our senior debt and common stock warrant investments in Biddeford Textile Corp. in connection with a sale of Biddeford Textile’s assets under a plan of reorganization under Chapter 11 of the Bankruptcy Code. We recognized a net realized loss of $1,100 on our senior debt and common stock warrants investment, which had a cost basis of $3,632. The assets securing the Biddeford Textile’s debt were purchased by Biddeford Real Estate Holdings, Inc., which was capitalized by us with senior debt and equity investments.

Unrealized Appreciation and Depreciation of Investments

The net unrealized depreciation and appreciation of investments is based on portfolio asset valuations determined by our board of directors. The following table itemizes the change in net unrealized (depreciation) appreciation of investments for 2003 and 2002:

The gross unrealized depreciation of investments above includes $1,110 and $1,128 for 2003 and 2002, respectively, resulting from our change in accounting principle adopted during 2001 related to debt discounts attributable to loan originations through December 31, 2000.

The fair value of the interest rate hedging agreements represents the estimated net present value of the future cash flows using a forward interest rate yield curve in effect at the end of the period. A negative fair value would represent an amount we would have to pay the other party and a positive fair value would represent an amount we would receive from the other party to terminate the agreement. They appreciate or depreciate based on relative market interest rates and their remaining term to maturity.

As part of our quarterly process of valuing our investment portfolio, we engaged Houlihan Lokey Howard & Zukin Financial Advisors, Inc. in the third quarter of 2003 to independently review, on a quarterly basis, the determination of fair value of a portion of American Capital’s portfolio company investments. Houlihan Lokey is the premier valuation firm in the U.S., engaged in approximately 800 valuation assignments per year for clients worldwide.

As part of its engagement, Houlihan Lokey reviews quarterly a random selection of approximately 25% of our portfolio companies, with the intention of reviewing all portfolio company investments over the course of a year. Houlihan Lokey attends American Capital’s quarterly valuation meetings and provides periodic reports and recommendations to our audit committee with respect to our valuation models, policies and procedures.

For the fourth quarter of 2003, Houlihan Lokey reviewed our valuations of approximately 25% of American Capital’s portfolio company investments, representing 22 companies, having $490 million in aggregate fair value as reflected in our financial statements as of December 31, 2003. Using methods and techniques that are customary for the industry and that Houlihan Lokey considers appropriate under the circumstances, Houlihan Lokey determined that the aggregate fair value assigned to the portfolio company investments by American

23

Capital was within their reasonable range of aggregate value for such companies. Houlihan Lokey came to the same determination on a different set of 20 portfolio companies, totaling $401 million in aggregate fair value as of September 30, 2003. As of December 31, 2003, Houlihan Lokey has now reviewed approximately 50% of the portfolio.

Fiscal Year 2002 Compared to Fiscal Year 2001

Operating Income

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

Interest income on debt securities increased by $42,467, or 49%, to $129,180 for 2002 from $86,713 for 2001. Our daily weighted average debt investments at cost, excluding discounts, increased from $614,800 in 2001 to $950,500 in 2002 resulting from new loan originations net of loan repayments during the last twelve months ended December 31, 2002. The daily weighted average interest rate on debt investments decreased to 13.6% in 2002 from 14.1% in 2001 due partially to a decrease in the weighted average monthly prime lending rate from 6.33% in 2001 to 4.68% in 2002 and a decrease in the average monthly LIBOR rate from 3.70% 2001 to 1.76% in 2002. The decrease in the weighted average interest rate on debt securities is also partially due to an increase in the average non-accruing loans from $25,000 in 2001 to $66,956 in 2002.

To match the interest rate basis of our assets and liabilities and to fulfill our obligations under the terms of our revolving debt funding facility and asset securitizations, we enter into interest rate swap agreements to hedge securitized debt investments in which we either pay a floating rate based on the prime rate and receive a floating rate based on LIBOR or pay a fixed rate and receive a floating rate based on LIBOR. Use of the interest rate swaps enables us to manage the impact of changing interest rates on spreads between the yield on our investments and the cost of our borrowings. As a result, both interest income and interest expense are affected by changes in LIBOR. See “Quantitative and Qualitative Disclosure About Market Risk” for a discussion of our use of interest rate swaps to mitigate the impact of interest rate changes on net operating income. The cost of the interest rate hedging agreements increased by $9,305, from $1,848 for 2001 to $11,153 for 2002. The daily weighted average interest rate on debt investments, including the impact of interest rate swaps, decreased to 12.4% in 2002 from 13.8% in 2001, due to the reasons noted above. The quarterly average notional amount of interest rate swaps as a percentage of the daily weighted average debt investments increased from 43.4% in 2001 to 52.3% 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. Our daily weighted average total debt and equity investments at cost increased from $659,700 in 2001 to $1,078,300 in 2002. The daily weighted average yield on total debt and equity investments, including the impact of interest rate swaps, decreased to 11.2% in 2002 from 13.1% in 2001 primarily due to the reasons noted above.

24

Fee income consisted of the following for 2002 and 2001:

Fee income increased by $9,003, or 56%, to $24,954 in 2002 from $15,951 in 2001. We recorded $4,904 in transaction structuring fees for ten buyout totaling $245,300 of American Capital financing in 2002 compared to $3,207 for four buyout investments totaling $106,000 of American Capital financing in 2001. The transaction structuring fees were 2.0% and 3.0% of buyout investments in 2002 and 2001, respectively. The increase in financing fees was attributable to an increase in new debt investments 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. Interest expense increased from $10,343 for 2001 to $14,321 for 2003 due to an increase in our weighted average borrowings from $175,600 for 2001 to $416,800 for 2002, net of a decrease in the weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 5.88% for 2001 to 3.43% for 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 2001 to 1.76% in 2002. Salaries and benefits expense increased from $14,571 for 2001 to $18,621 for 2002 due to an increase in employees from 68 at December 31, 2001 to 108 at December 31, 2002 and annual salary rate increases, partially offset by a decrease in our incentive compensation as a percentage of our total salary expense. General and administrative expenses increased from $7,698 for 2001 to $11,531 for 2002 primarily due to higher facilities expenses, insurance expense, reserves for uncollectible amounts, board of directors’ fees, and financial reporting expenses.

25

Net Realized Gains (Losses)

See “Fiscal Year 2003 Compared to Fiscal Year 2002” for discussion on the net realized gains (losses) for the year ended December 31, 2002.

During 2001, we exited our investment in Cornell Companies, Inc. through a sale of our common stock warrants and the prepayment of our subordinated debt. We recognized a net realized gain of $2,140. The realized gain was comprised of a $1,257 realization of unamortized OID on the subordinated debt and $883 of gain on the common stock warrants. In addition, we received a prepayment fee of $588.

During 2001, we sold our investment in BIW Connector Systems, LLC. Our investment in BIW included senior debt and senior subordinated debt with common stock warrants. We recognized a net realized gain of $1,823 which was comprised of a $418 realization of OID on the subordinated debt and $1,405 of gain on the common stock warrants.

During 2001, we converted our common stock investment in Mobile Tool, Inc. to subordinated debt by exercising our put rights and recognized a realized gain of $2,452 on this conversion. Also during 2001, we realized losses on the write-off of our common stock investments of $500 on the sale of Erie Forge & Steel, Inc. and $592 on Biddeford Textile, which filed for bankruptcy protection under Chapter 11.

26

Unrealized Appreciation and Depreciation of Investments

The net unrealized depreciation and appreciation of investments is based on portfolio asset valuations determined by our board of directors. The following table itemizes the change in net unrealized (depreciation) appreciation of investments for 2002 and 2001:

The gross unrealized depreciation of investments above includes $1,128 and $1,335 for 2002 and 2001, respectively, resulting from our change in accounting principle adopted during 2001 related to debt discounts attributable to loan originations through December 31, 2000.

The fair value of the interest rate hedging agreements represents the estimated net present value of the future cash flows using a forward interest rate yield curve in effect at the end of the period. A negative fair value would represent an amount we would have to pay the other party and a positive fair value would represent an amount we would receive from the other party to terminate the agreement. They appreciate or depreciate based on relative market interest rates and their remaining term to maturity.

Financial Condition, Liquidity, and Capital Resources

At December 31, 2003, we had $8,020 in cash and cash equivalents and $75,935 of restricted cash. Our restricted cash consists primarily of escrows of interest and principal payments collected on assets that are securitized. In accordance with the terms of the related securitized debt agreements, those funds are distributed each month to pay interest and principal on the securitized debt. We had outstanding debt secured by our assets of $116,000 under a revolving debt funding facility and $724,211 under five asset securitizations. As of December 31, 2003, we had availability under our revolving debt funding facility of $109,000. During 2003, we principally funded investments using draws on the revolving debt funding facility, proceeds from asset securitizations and equity offerings.

As a regulated investment company, we are required to distribute annually 90% or more of our investment company taxable income and 98% of our net realized short-term capital gains to shareholders. We provide shareholders with the option of reinvesting their distributions in American Capital. In 2003, 2002 and 2001, shareholders reinvested $803, $961 and $1,048, respectively, in dividends. Since our IPO, shareholders have reinvested $4,375 of dividends in American Capital. While we will continue to provide shareholders with the option of reinvesting their distributions in American Capital, we have historically and anticipate having to issue debt or equity securities in addition to the above borrowings to expand our 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 us on terms we deem favorable. We expect to continue to raise debt and equity capital during the year ended December 31, 2004 to fund our new investments for 2004.

Our wholly-owned operating subsidiary, ACFS, is subject to corporate level federal and state income tax. During fiscal years 2003, 2002 and 2001, ACFS operated at either a taxable loss or utilized a net operating loss carry forward. As of December 31, 2003, ACFS’ net operating loss was fully utilized. We may, through ACFS, have taxable income in 2004 and forward that would be subject to the payment of federal and state income taxes.

27

Equity Capital Raising Activities

On June 17, 2003, we filed a shelf registration statement with the Securities and Exchange Commission, with respect to our debt and equity securities. The shelf registration statement allows us to sell our 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, we had no remaining capacity under the shelf registration statement.

In February 2004, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $59,403 in exchange for 1,890 common shares. Subsequently in March 2004, we sold 284 shares of our common stock pursuant to the underwriters’ over-allotment previously granted and received proceeds, net of the underwriters’ discount, of $8,910.

In November 2003, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $194,735 in exchange for 7,600 common shares. Subsequently in November 2003, we sold 1,140 shares of our common stock pursuant to the underwriters’ over-allotment previously granted and received proceeds, net of the underwriters’ discount, of $29,210.

In September 2003, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $47,364 in exchange for 2,000 common shares. Subsequently in October 2003, we sold 188 shares of our common stock pursuant to the underwriters’ over-allotment option previously granted and received proceeds, net of the underwriters’ discount, of $4,462.

In March 2003, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $124,657 in exchange for 5,800 common shares. Subsequently in March 2003, we sold 870 shares of our common stock pursuant to the underwriters’ over-allotment option previously granted and received proceeds, net of the underwriters’ discount, of $18,699.

In January 2003, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $88,724 in exchange for 4,100 common shares. Subsequently in January 2003, we sold 615 shares of our common stock pursuant to the underwriters’ over-allotment option previously granted and received proceeds, net of the underwriters’ discount, of $13,309.

In November 2002, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $44,507 in exchange for 2,600 common shares. Subsequently in December 2002, we sold 390 shares of our common stock pursuant to the underwriters’ over-allotment option previously granted and received proceeds, net of the underwriters’ discount, of $6,676.

In July 2002, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $73,084 in exchange for 2,900 common shares.

In December 2001, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $44,783 in exchange for 1,700 common shares. Subsequently in December 2001, we sold 255 shares of our common stock pursuant to the underwriters’ over-allotment option previously granted and received proceeds, net of the underwriters’ discount, of $6,717.

In September 2001, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of $49,500 in exchange for 1,800 common shares.

In June 2001, we completed a public offering of our common stock and received proceeds, net of the underwriters’ discount, of approximately $109,127 exchange for 4,500 common shares. Subsequently in June 2001, we sold 675 shares of our common stock pursuant to the underwriters’ over-allotment option previously granted and received proceeds, net of the underwriters’ discount, of $16,369.

28

Debt Capital Raising Activities

Our debt obligations consisted of the following as of December 31, 2003 and 2002:

As of December 31, 2003 and 2002, we, through ACS Funding Trust I (“Trust I”), an affiliated business trust, had $116,000 and $255,793, respectively, in borrowings outstanding under a revolving debt-funding facility. On June 13, 2003, we and ACS Funding Trust I entered into an amended and restated loan funding and service agreement with the existing lenders with an aggregate commitment of $225,000. On October 8, 2003, we received a temporary increase in the aggregate commitment of our revolving credit facility from $225,000 to $305,000. The commitment reverted back to $225,000 on December 19, 2003. The revolving debt funding facility expires on June 11, 2004 with any outstanding principal amount amortized over a 24-month period through a termination date of June 13, 2006. As of December 31, 2003, this facility was collateralized by our loans with a principal balance of $355,285. Interest on borrowings under this facility is paid monthly and is charged at either one-month LIBOR or a commercial paper rate (1.12% at December 31, 2003) plus a spread. We are also charged an unused commitment fee of 0.15%.

During 2003, we sold all or a portion of certain senior loans under repurchase agreements. The repurchase agreements are short-term financing, in which we sell the senior loans for a sale price generally ranging from 70% to 80% of the face amount of the senior loans and we have an obligation to repurchase the senior loans at the original sale price on a future date. We are required to make payments to the purchaser equal to one-month LIBOR plus 250 basis points of the sales price. The purchaser is entitled to receive all interest and principal on the senior loans and required to remit all interest and principal payments to us. The purchaser cannot repledge or sell the loans. We have treated the repurchase agreements as secured financing arrangements. The sale price of the senior loans would be included as a debt obligation on the accompanying consolidated balance sheets. As of December 31, 2003, we had no amounts outstanding under the repurchase agreements.

On December 19, 2003, we completed a $317,500 asset securitization. In connection with the transaction, we established ACAS Business Loan Trust 2003-2 (“Trust VI”), an affiliated statutory trust, and contributed to Trust VI $398,000 in loans. Subject to continuing compliance with certain conditions, we will remain as servicer of the loans. Simultaneously with the initial contribution, Trust VI was authorized to issue $258,000 Class A notes, $40,000 Class B notes, $20,000 Class C notes, $40,000 Class D notes, and $40,000 of Class E notes. The Class A notes, Class B notes and Class C notes were issued to institutional investors and the Class D and Class E notes were retained by us. The Class A notes carry an interest rate of one-month LIBOR plus 48 basis points, the Class B notes carry an interest rate of one-month LIBOR plus 95 basis points, and the Class C notes carry an interest rate of one-month LIBOR plus 175 basis points. The loans are secured by loans from our portfolio companies with a principal balance of $396,927 as of December 31, 2003. The Class A notes mature on November 20, 2008, the Class B notes mature on June 20, 2009, and the Class C notes mature on August 20, 2009. Early repayments are first applied to the Class A notes, then to the Class B notes and then to the Class C notes.

On May 21, 2003, we completed a $238,700 asset securitization. In connection with the transaction, we established ACAS Business Loan Trust 2003-1 (“Trust V”), an affiliated statutory trust, and contributed to Trust V $308,000 in loans. Subject to continuing compliance with certain conditions, we will remain as servicer of the

29

loans. Simultaneously with the initial contribution, Trust V was authorized to issue $185,000 Class A notes, $31,000 Class B notes, $23,000 Class C notes and $69,000 Class D notes. The Class A notes, Class B notes and Class C notes were issued to institutional investors and the Class D notes were retained by us. The Class C notes consist of a $17,000 tranche of floating rate notes and a $6,000 tranche of fixed rate notes. The Class A notes carry an interest rate of one-month LIBOR plus 55 basis points and the Class B notes carry an interest rate of one-month LIBOR plus 120 basis points. The floating rate tranche of the Class C notes carries an interest rate of one-month LIBOR plus 225 basis points and the fixed rate tranche carries an interest rate of 5.14%. The loans are secured by loans from our portfolio companies with a principal balance of $290,611 as of December 31, 2003. The Class A notes mature on March 20, 2008, the Class B notes mature on September 20, 2008 and the Class C notes mature on December 20, 2008. Early repayments are first applied to the Class A notes, then to the Class B notes and then to the Class C notes.

On August 8, 2002, we completed a $157,900 asset securitization. In connection with the transaction, we 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, we 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 us. The Class A notes carry an interest rate of one-month LIBOR plus 50 basis points, and the Class B notes carry an interest rate of one-month LIBOR plus 160 basis points. The notes are secured by loans from our portfolio companies with a principal balance of $156,135 as of December 31, 2003. 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.

On March 15, 2002, we completed a $147,300 asset securitization. In connection with the transaction, we 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, we 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 us. The Class A notes carry an interest rate of one-month LIBOR plus 50 basis points, and the Class B notes carry an interest rate of one-month LIBOR plus 150 basis points. The notes are secured by loans from our portfolio companies with a principal balance of $91,961 as of December 31, 2003. 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.

On December 20, 2000, we completed a $115,400 asset securitization. In conjunction with the transaction, we 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, we 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 us. The Class A notes carry an interest rate of one-month LIBOR plus 45 basis points, and the Class B notes carry an interest rate of one-month LIBOR plus 150 basis points. The notes are secured by loans from our portfolio companies with a principal balance of $77,815 as of December 31, 2003. 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.

The weighted average debt balance for the years ended December 31, 2003 and 2002 was $582,200 and $416,800, respectively. The weighted average interest rate on all of our borrowings, including amortization of deferred financing costs, for the years ended December 31, 2003, 2002 and 2001 was 3.18%, 3.43% and 5.88%, respectively.