ALLIED CAPITAL CORP, N-2/A, 1999-05-06

ALLIED CAPITAL CORP
N-2/A, 1999-05-06

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<PAGE> 1

As filed with the Securities and Exchange Commission on May 6, 1999

REGISTRATION NO. 333-75161

- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM N-2

REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933

[X] PRE-EFFECTIVE AMENDMENT NO. 1

[ ] POST-EFFECTIVE AMENDMENT NO.

ALLIED CAPITAL CORPORATION
(Exact Name of Registrant as Specified in Charter)

1919 PENNSYLVANIA AVENUE, N.W.
WASHINGTON, D.C. 20006-3434
(202) 331-1112
(Address and Telephone Number, including Area Code, of Principal Executive
Offices)

WILLIAM L. WALTON, CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER
ALLIED CAPITAL CORPORATION
1919 PENNSYLVANIA AVENUE, N.W.
WASHINGTON, D.C. 20006-3434
(Name and Address of Agent for Service)

Copies of information to:

<TABLE>
<S> <C>
STEVEN B. BOEHM
SUTHERLAND ASBILL & BRENNAN LLP
1275 PENNSYLVANIA AVENUE, N.W.
WASHINGTON, D.C. 20004-2415
</TABLE>

Approximate Date of Proposed Public Offering:
From time to time after the effective date of the Registration Statement.

If any securities being registered on this form will be offered on a
delayed or continuous basis in reliance on Rule 415 under the Securities Act of
1933, other than securities offered in connection with a dividend reinvestment
plan, check the following box. [X]

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT
SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO
SECTION 8(a), MAY DETERMINE.

- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE> 2

ALLIED CAPITAL CORPORATION

CROSS-REFERENCE SHEET
SHOWING LOCATION IN PROSPECTUS AND STATEMENT OF ADDITIONAL INFORMATION OF
INFORMATION REQUIRED BY PARTS A AND B OF FORM N-2 REGISTRATION STATEMENT

<TABLE>
<CAPTION>
ITEM CAPTION OR LOCATION IN PROSPECTUS OR
NUMBER REGISTRATION STATEMENT ITEM AND HEADING STATEMENT OF ADDITIONAL INFORMATION
- ------ --------------------------------------- ------------------------------------
<C> <S> <C>
PART A: INFORMATION REQUIRED IN A PROSPECTUS

1. Outside Front Cover................... Outside front cover page
2. Cover Pages; Other Offering
Information......................... Inside front cover page
3. Fee Table and Synopsis................ Prospectus Summary; Fees and Expenses;
Where You Can Find Additional
Information
4. Financial Highlights.................. Selected Consolidated Financial Data
5. Plan of Distribution.................. Plan of Distribution
6. Selling Shareholders.................. Not Applicable
7. Use of Proceeds....................... Use of Proceeds
8. General Description of the
Registrant.......................... Outside front cover; Prospectus
Summary; Risk Factors; The Company;
Business; Price Range of Common
Stock and Dividends; Senior
Securities; Portfolio Companies;
Financial Statements
9. Management............................ Management; Safekeeping, Transfer and
Dividend Paying Agent and Registrar
10. Capital Stock, Long-Term Debt, and
Other Securities.................... Price Range of Common Stock and
Dividends; Dividend Reinvestment
Plan; Taxation; Certain Government
Regulations; Description of Capital
Stock
11. Defaults and Arrears on Senior
Securities.......................... Not Applicable
12. Legal Proceedings..................... Business -- Legal Proceedings
13. Table of Contents of the Statement of
Additional Information.............. Table of Contents of the Statement of
Additional Information

PART B: INFORMATION REQUIRED IN A STATEMENT OF ADDITIONAL INFORMATION

14. Cover Page............................ Outside front cover page of Statement
of Additional Information
15. Table of Contents..................... Outside front cover page of Statement
of Additional Information
16. General Information and History....... General Information and History
17. Investment Objective and Policies..... Investment Objectives and Policies
18. Management............................ Management
19. Control Persons and Principal
Shareholders........................ Control Persons and Principal Holders
of Securities
20. Investment Advisory and Other
Services............................ Investment Advisory Services;
Safekeeping, Transfer and Dividend
Paying Agent and Registrar;
Accounting Services
21. Brokerage Allocation and Other
Practices........................... Brokerage Allocation and Other
Practices
22. Tax Status............................ Tax Status
23. Financial Statements.................. Financial Statements in Prospectus

PART C: OTHER INFORMATION
</TABLE>

Information required to be included in Part C is set forth under the
appropriate item, so numbered, in Part C to this registration statement.
<PAGE> 3

PROSPECTUS (SUBJECT TO COMPLETION)
ISSUED , 1999

[Allied Capital Logo] 6,000,000 SHARES

ALLIED CAPITAL CORPORATION

COMMON STOCK
------------------------

Please read this prospectus, and the accompanying prospectus supplement, if any,
before investing, and keep it for future reference. It contains important
information about the Company.

To learn more about the Company, you may want to look at the Statement of
Additional Information dated May , 1999 (known as the "SAI"). For a free copy
of the SAI, contact us at:

Allied Capital Corporation
1919 Pennsylvania Avenue, N.W.
Washington, DC 20006
1-888-818-5298

The Company has filed the SAI with the U.S. Securities and Exchange Commission
and has incorporated it by reference into this prospectus. The SAI's table of
contents appears on page 61 of this prospectus.

The Commission maintains an Internet website (http://www.sec.gov) that contains
the SAI, material incorporated by reference and other information about the
Company.

We may offer, from time to time, up to 6,000,000 shares of common stock, par
value $0.0001 per share, on terms to be determined at the time of offering. The
shares may be offered at prices and on terms to be described in one or more
supplements to this prospectus, provided, however, that the offering price per
share, less any underwriting commissions or discounts, must equal or exceed the
net asset value per share of our common stock.

We are an internally managed closed-end management investment company that has
elected to be regulated as a business development company under the Investment
Company Act of 1940, as amended.

Our investment objective is to achieve current income and capital gains. We seek
to achieve our investment objective by investing primarily in private small to
medium-sized growing businesses in a variety of industries and in diverse
geographic locations, primarily in the United States. No assurances can be given
that we will continue to achieve our objective.

Our common stock is traded on the Nasdaq National Market under the symbol
"ALLC." As of , 1999, the last reported sales price for the
common stock was $ .

YOU SHOULD REVIEW THE INFORMATION INCLUDING THE RISK OF LEVERAGE, SET FORTH
UNDER "RISK FACTORS" ON PAGE 7 OF THIS PROSPECTUS BEFORE INVESTING IN COMMON
STOCK OF THE COMPANY.
------------------------
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATIONS TO THE CONTRARY
IS A CRIMINAL OFFENSE.
------------------------

, 1999

THE INFORMATION IN THIS PROSPECTUS IS NOT COMPLETE AND MAY BE CHANGED. WE
MAY NOT SELL THESE SECURITIES UNTIL THE REGISTRATION STATEMENT FILED WITH
THE SECURITIES AND EXCHANGE COMMISSION IS EFFECTIVE. THIS PROSPECTUS IS
NOT AN OFFER TO SELL THESE SECURITIES AND IS NOT SOLICITING AN OFFER TO
BUY THESE SECURITIES IN ANY STATE WHERE THE OFFER OR SALE IS NOT
PERMITTED.
<PAGE> 4

WE HAVE NOT AUTHORIZED ANY DEALER, SALESMAN OR OTHER PERSON TO GIVE ANY
INFORMATION OR TO MAKE ANY REPRESENTATION OTHER THAN THOSE CONTAINED OR
INCORPORATED BY REFERENCE IN THIS PROSPECTUS OR ANY ACCOMPANYING SUPPLEMENT TO
THIS PROSPECTUS. YOU MUST NOT RELY UPON ANY INFORMATION OR REPRESENTATION NOT
CONTAINED OR INCORPORATED BY REFERENCE IN THIS PROSPECTUS OR THE ACCOMPANYING
PROSPECTUS SUPPLEMENT AS IF WE HAD AUTHORIZED IT. THIS PROSPECTUS AND ANY
PROSPECTUS SUPPLEMENT DO NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF
ANY OFFER TO BUY ANY SECURITY OTHER THAN THE REGISTERED SECURITIES TO WHICH THEY
RELATE, NOR DO THEY CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO
BUY ANY SECURITIES IN ANY JURISDICTION TO ANY PERSON TO WHOM IT IS UNLAWFUL TO
MAKE SUCH AN OFFER OR SOLICITATION IN SUCH JURISDICTION. THE INFORMATION
CONTAINED IN THIS PROSPECTUS AND ANY PROSPECTUS SUPPLEMENT IS ACCURATE AS OF THE
DATES ON THEIR COVERS.

------------------------

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary.......................................... 1
Selected Consolidated Financial Data........................ 4
Risk Factors................................................ 7
The Company................................................. 11
Use of Proceeds............................................. 11
Price Range of Common Stock and Dividends................... 12
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 13
Senior Securities........................................... 31
Business.................................................... 35
Portfolio Companies......................................... 46
Determination of Net Asset Value............................ 50
Management.................................................. 51
Taxation.................................................... 56
Certain Government Regulations.............................. 58
Dividend Reinvestment Plan.................................. 61
Description of Capital Stock................................ 61
Plan of Distribution........................................ 65
Legal Matters............................................... 66
Safekeeping, Transfer and Dividend Paying Agent and
Registrar................................................. 66
Independent Public Accountants.............................. 66
Table of Contents of Statement of Additional Information.... 67
Index to Financial Statements............................... 68
</TABLE>

------------------------

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

INFORMATION CONTAINED OR INCORPORATED BY REFERENCE IN THIS PROSPECTUS, AND
THE ACCOMPANYING PROSPECTUS SUPPLEMENT, IF ANY, MAY CONTAIN "FORWARD-LOOKING
STATEMENTS" WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT
OF 1995, WHICH CAN BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH
AS "MAY," "WILL," "EXPECT," "INTEND," "ANTICIPATE," "ESTIMATE" OR "CONTINUE" OR
THE NEGATIVE THEREOF OR OTHER VARIATIONS OR SIMILAR WORDS OR PHRASES. THE
MATTERS DESCRIBED IN "RISK FACTORS" AND CERTAIN OTHER FACTORS NOTED THROUGHOUT
THIS PROSPECTUS, AND THE ACCOMPANYING PROSPECTUS SUPPLEMENT, IF ANY, AND IN ANY
EXHIBITS TO THE REGISTRATION STATEMENT OF WHICH THIS PROSPECTUS, AND THE
ACCOMPANYING PROSPECTUS SUPPLEMENT, IF ANY, IS A PART, CONSTITUTE CAUTIONARY
STATEMENTS IDENTIFYING IMPORTANT FACTORS WITH RESPECT TO ANY SUCH
FORWARD-LOOKING STATEMENTS, INCLUDING CERTAIN RISKS AND UNCERTAINTIES, THAT
COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN SUCH
FORWARD-LOOKING STATEMENTS.

(i)
<PAGE> 5

PROSPECTUS SUMMARY

The following summary contains basic information about this offering. It
likely does not contain all the information that is important to an investor.
For a more complete understanding of this offering, we encourage you to read
this entire document and the documents to which we have referred.

Our current business and investment portfolio resulted from the merger of
five affiliated companies on December 31, 1997. The companies that merged were
Allied Capital Corporation (old), Allied Capital Corporation II, Allied Capital
Advisers, Inc., Allied Capital Commercial Corporation and Allied Capital Lending
Corporation. The five companies are referred to as the predecessor companies.

All information in this prospectus, unless otherwise indicated, has been
presented as if the predecessor companies had merged as of the beginning of the
earliest period presented. In this prospectus or any accompanying prospectus
supplement, unless otherwise indicated, the "Company", "ACC", "we", "us" or
"our" refer to the post-merger Allied Capital Corporation and its subsidiaries.

THE COMPANY (Page 11)

We are a lender to and investor in private small and medium-sized
businesses. We have been lending to private growing businesses for 40 years and
have financed thousands of borrowers nationwide in a variety of industries. Our
lending operations are conducted in three primary areas:

- mezzanine finance,

- commercial real estate finance, including the purchase of commercial
mortgage-backed securities ("CMBS"), and

- Small Business Administration 7(a) lending.

Our principal loan products include:

- subordinated loans with equity features,

- commercial mortgage loans, and

- SBA 7(a) guaranteed loans.

We are a value-added full-service lender, and we source loans and
investments through our numerous relationships with:

- regional and boutique investment banks,

- mezzanine and private equity investors, and

- other intermediaries, including professional services firms.

In order to increase our sourcing and origination activities, we have regional
offices in Chicago and San Francisco, and offices focused on small business
lending in Detroit, Atlanta, and Philadelphia. We centralize our credit approval
function and service our loans through an experienced staff of professionals at
our headquarters in Washington, DC. Our common stock is quoted on the Nasdaq
National Market under the symbol "ALLC."

We have an advantageous structure that allows for the "pass-through" of
income to our shareholders without the imposition of a corporate level of
taxation. See "Taxation."

We are an internally managed closed-end management investment company that
has elected to be regulated as a business development company ("BDC") under the
Investment Company Act of 1940, as amended ("1940 Act"). Our investment
objective is to achieve current income and capital gains. We seek to achieve our
investment objective by investing in growing businesses in a variety of
industries and in diverse geographic locations, primarily in the United States.

1
<PAGE> 6

THE OFFERING (Page 65)

We may offer, from time to time, up to 6,000,000 shares of common stock,
par value $0.0001 per share, on terms to be determined at the time of offering.
Shares may be offered at prices and on terms described in one or more
supplements to this prospectus, provided, however, that the offering price per
share, less any underwriting commissions or discounts, must equal or exceed the
net asset value per share of our common stock.

We may offer shares directly to one or more purchasers, through agents we
designate, or to or through underwriters or dealers. If any agents or
underwriters are involved in the sale of shares, their names, and any applicable
purchase price, fee, commission or discount, will be described in an
accompanying prospectus supplement. We will not sell shares without delivering a
prospectus supplement describing the method and terms of the offering of such
shares.

USE OF PROCEEDS (Page 11)

Unless otherwise specified in the prospectus supplement accompanying this
prospectus, we intend to use the net proceeds from selling shares for general
corporate purposes, which may include investment in small to medium-sized,
private growth companies in accordance with our investment objective, purchase
of commercial mortgage-backed securities, repayment of indebtedness,
acquisitions and other general corporate purposes.

DIVIDENDS (Page 12)

We pay quarterly dividends to shareholders. The amount of our quarterly
dividends is determined by the board of directors and is based upon our estimate
of annual taxable income.

DIVIDEND REINVESTMENT PLAN (Page 61)

We have adopted an "opt out" dividend reinvestment plan ("DRIP plan").
Under the DRIP plan, if your shares are registered in your name, your dividends
will be automatically reinvested in additional shares of common stock unless you
"opt out" of the DRIP plan.

PRINCIPAL RISK FACTORS (Page 7)

Investment in shares of common stock involves certain risks relating to our
structure and our investment objective that you should consider before
purchasing shares.

As a BDC, our consolidated portfolio includes securities primarily issued
by privately held companies. These investments may involve a high degree of
business and financial risk, and they are generally illiquid. A large number of
entities and individuals compete for the same kind of investment opportunities
as we do. We borrow funds to make investments in and loans to small and
medium-sized businesses. As a result, we are exposed to the risks of leverage,
which may be considered a speculative investment technique. In addition, the
loss of pass-through tax treatment could have a material adverse effect on our
total return, if any.

CERTAIN ANTI-TAKEOVER PROVISIONS (Page 62)

Our charter and bylaws, as well as certain statutory and regulatory
requirements, contain certain provisions that may have the effect of
discouraging a third party from making an acquisition proposal for the Company.
These anti-takeover provisions may inhibit a change in control in circumstances
that could give the holders of common stock the opportunity to realize a premium
over the market price for the common stock.

2
<PAGE> 7

FEES AND EXPENSES

This table describes the various costs and expenses that an investor in the
Company will bear directly or indirectly.

<TABLE>
<S> <C>
SHAREHOLDER TRANSACTION EXPENSES
Sales load (as a percentage of offering price)(1)....... --%
Dividend reinvestment plan fees(2)...................... None

ANNUAL EXPENSES (AS A PERCENTAGE OF CONSOLIDATED NET ASSETS
ATTRIBUTABLE TO COMMON SHARES)(3)
Operating expenses(4)................................... 5.5%
Interest payments on borrowed funds(5).................. 7.3%
-----
Total annual expenses(6)........................... 12.8%
=====
</TABLE>

- -------------------------
(1) In the event that shares to which this prospectus relates are sold to or
through underwriters, a corresponding prospectus supplement will disclose
the applicable sales load.

(2) The expenses of the Company's DRIP plan are included in "Operating
expenses." The Company has no cash purchase plan. The participants in the
DRIP plan will bear a pro rata share of brokerage commissions incurred with
respect to open market purchases, if any. See "Dividend Reinvestment Plan."

(3) "Consolidated net assets attributable to common shares" equals net assets
(i.e., total assets less total liabilities and preferred stock) at March 31,
1999.

(4) "Operating expenses" represent the estimated operating expenses of the
Company for the year ended December 31, 1999 excluding interest on
indebtedness. Operating expenses exclude the formula and cut-off awards. See
"Management -- Compensation Plans."

(5) The "Interest payments on borrowed funds" percentage is based on estimated
interest payments for the year ended December 31, 1999 divided by
consolidated net assets attributable to common shares. The Company had
outstanding borrowings of $410.7 million at March 31, 1999. This percentage
for the year ended December 31, 1998 was 4.2%. See "Risk Factors."

(6) "Total annual expenses" as a percentage is based on estimated amounts for
the year ended December 31, 1999. "Total annual expenses" as a percentage of
consolidated net assets attributable to common shares are higher than the
total annual expenses percentage would be for a company that is not
leveraged. The Company borrows money to leverage its net assets and increase
its total assets. The Securities and Exchange Commission requires that the
"Total annual expenses" percentage be calculated as a percentage of net
assets, rather than the total assets, including assets that have been funded
with borrowed money. If the "Total annual expenses" percentage were
calculated instead as a percentage of consolidated total assets, "Total
annual expenses" for the Company would be 6.9% of consolidated total assets.

EXAMPLE

The following example, required by the Commission, demonstrates the
projected dollar amount of total cumulative expenses that would be incurred over
various periods with respect to a hypothetical investment in the Company. In
calculating the following expense amounts, we assumed we would have no
additional leverage and that our operating expenses would remain at the levels
set forth in the table above. In the event that shares to which this prospectus
relates are sold to or through underwriters, a corresponding prospectus
supplement will restate this example to reflect the applicable sales load.

<TABLE>
<CAPTION>
1 YEAR 3 YEARS 5 YEARS 10 YEARS
------ ------- ------- --------
<S> <C> <C> <C> <C>
You would pay the following expenses on a $1,000
investment, assuming a 5.0% annual return........ $126 $372 $608 $1,159
</TABLE>

Although the example assumes (as required by the Commission) a 5.0% annual
return, our performance will vary and may result in a return of greater or less
than 5.0%. In addition, while the example assumes reinvestment of all dividends
and distributions at net asset value, participants in the DRIP plan may receive
shares that we issue at or above net asset value or are purchased by the
administrator of the DRIP plan, at the market price in effect at the time, which
may be higher than, at, or below net asset value. See "Dividend Reinvestment
Plan."

THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF FUTURE EXPENSES, AND
THE ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN.
3
<PAGE> 8

SELECTED CONSOLIDATED FINANCIAL DATA

You should read the consolidated financial information below with the
Consolidated Financial Statements and Notes thereto included in this prospectus.
Financial information for the years ended December 31, 1998, 1997, 1996 and 1995
has been derived from audited financial statements. Financial information for
the year ended December 31, 1994 has been derived from the audited financial
statements of the individual predecessor companies. The selected financial data
reflects the operations of the Company with all periods restated as if the
predecessor companies had merged as of the beginning of the earliest period
presented. Quarterly financial information is derived from unaudited financial
data, but in the opinion of management, reflects all adjustments (consisting
only of normal recurring adjustments) which are necessary to present fairly the
results for such interim periods. Interim results at and for the three months
ended March 31, 1999 are not necessarily indicative of the results that may be
expected for the year ending December 31, 1999. SEE "MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" ON PAGE 13 FOR MORE
INFORMATION.

<TABLE>
<CAPTION>
THREE MONTHS
ENDED MARCH 31, YEAR ENDED DECEMBER 31,
----------------- -----------------------------------------------
1999 1998 1998 1997 1996 1995 1994
------- ------- ------- ------- ------- ------- -------
OPERATING DATA: (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
Interest and related portfolio
income:
Interest..................... $24,684 $19,501 $79,921 $86,882 $77,541 $61,550 $47,065
Net premiums from loan
dispositions............... 1,901 1,336 5,949 7,277 4,241 2,796 2,380
Net gain on securitization of
commercial mortgage
loans...................... -- 14,812 14,812 -- -- -- --
Investment advisory fees and
other income............... 1,093 1,248 6,056 3,246 3,155 4,471 2,710
------- ------- ------- ------- ------- ------- -------
Total interest and
related portfolio
income................ 27,678 36,897 106,738 97,405 84,937 68,817 52,155
------- ------- ------- ------- ------- ------- -------
Expenses:
Interest on indebtedness..... 6,365 4,598 20,694 26,952 20,298 12,355 7,486
Salaries and employee
benefits................... 3,361 2,850 11,829 10,258 8,774 8,031 6,929
General and administrative... 2,350 2,757 11,921 8,970 8,289 6,888 7,170
Merger....................... -- -- -- 5,159 -- -- --
------- ------- ------- ------- ------- ------- -------
Total operating
expenses.............. 12,076 10,205 44,444 51,339 37,361 27,274 21,585
Formula and cut-off
awards(1).................. 1,772 1,772 7,049 -- -- -- --
------- ------- ------- ------- ------- ------- -------
Portfolio income before net
realized and unrealized
gains...................... 13,830 24,920 55,245 46,066 47,576 41,543 30,570
------- ------- ------- ------- ------- ------- -------
Net realized and unrealized
gains:
Net realized gains........... 466 6,421 22,541 10,704 19,155 12,000 6,236
Net unrealized gains
(losses)................... 4,284 724 1,079 7,209 (7,412) 9,266 (2,244)
------- ------- ------- ------- ------- ------- -------
Total net realized and
unrealized gains...... 4,750 7,145 23,620 17,913 11,743 21,266 3,992
------- ------- ------- ------- ------- ------- -------
Income before minority interests
and income taxes............... 18,580 32,065 78,865 63,979 59,319 62,809 34,562
Minority interests............... -- -- -- 1,231 2,427 546 --
Income tax expense............... -- -- 787 1,444 1,945 1,784 672
------- ------- ------- ------- ------- ------- -------
Net increase in net assets
resulting from operations...... $18,580 $32,065 $78,078 $61,304 $54,947 $60,479 $33,890
======= ======= ======= ======= ======= ======= =======
</TABLE>

(footnotes appear on next page)

4
<PAGE> 9

<TABLE>
<CAPTION>
AT MARCH 31, AT DECEMBER 31,
------------ ----------------------------------------------------
1999 1998 1997 1996 1995 1994
BALANCE SHEET DATA: ------------ -------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C>
Portfolio at value......... $885,838 $800,274 $697,021 $607,368 $528,483 $443,316
Portfolio at cost.......... 877,249 796,389 690,720 613,276 526,979 451,078
Total assets............... 961,421 856,079 807,775 713,360 605,434 501,817
Total debt
outstanding(4)........... 410,742 334,350 347,663 274,997 200,339 130,236
Preferred stock issued to
SBA(4)................... 7,000 7,000 7,000 7,000 7,000 7,000
Shareholders' equity....... 522,976 485,117 420,060 402,134 367,192 344,043
Shareholders' equity per
common share............. $ 8.98 $ 8.68 $ 8.07 $ 8.34 $ 8.26 $ 8.02
Common shares outstanding
at period end(3)......... 58,254 55,919 52,047 48,238 44,479 42,890
</TABLE>

<TABLE>
<CAPTION>
THREE MONTHS
ENDED MARCH 31, YEAR ENDED DECEMBER 31,
--------------------- ------------------------------------------------------
1999 1998 1998 1997 1996 1995 1994
OTHER DATA: ---------- -------- ---------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PERCENTAGES)
<S> <C> <C> <C> <C> <C> <C> <C>
Loan originations.... $ 159,740 $107,506 $ 524,530 $364,942 $283,295 $216,175 $215,843
Loan repayments...... 37,781 30,773 138,081 233,005 179,292 111,731 54,097
Loan sales(5)........ 40,467 9,706 81,013 53,912 27,715 29,726 30,160
Total assets managed
at period end(6)... 1,244,287 990,345 1,143,548 935,720 822,450 702,567 583,817
Realized gains....... 814 6,421 25,757 15,804 30,417 16,679 9,144
Realized losses...... (348) -- (3,216) (5,100) (11,262) (4,679) (2,908)
</TABLE>

- -------------------------

(1) See "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Results of Operations -- Comparison of Three Months Ended
March 31, 1999 and 1998 and Fiscal Years Ended December 31, 1998, 1997 and
1996."

(2) Distributions are based on taxable income, which differs from income for
financial reporting purposes. In 1997, Allied Capital Corporation (old)
distributed $0.34 per common share representing the 844,914 shares of Allied
Capital Lending Corporation distributed in conjunction with the merger. The
distribution resulted in a partial return of capital. Also in conjunction
with the merger, the Company distributed $0.17 per common share representing
the undistributed earnings of the predecessor companies at December 31,
1997.

(3) Excludes 563,537 shares and 810,456 shares held in the deferred compensation
trust at or for the three months ended March 31, 1999 and 1998,
respectively, and 810,456 shares held in the deferred compensation trust at
or for the year ended December 31, 1998.

(4) See "Senior Securities" on page 31 for more information regarding the
Company's level of indebtedness.

(5) Excludes loans sold through securitization in January 1998. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Results of Operations -- Comparison of Fiscal Years Ended
December 31, 1998, 1997 and 1996."

(6) Total assets managed includes the Company's assets and assets managed on
behalf of others.

5
<PAGE> 10

<TABLE>
<CAPTION>
1999 1998 1997
------- ------------------------------------- -------------------------------------
QTR 1 QTR 4 QTR 3 QTR 2 QTR 1 QTR 4 QTR 3 QTR 2 QTR 1
------- ------- ------- ------- ------- ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
QUARTERLY DATA:
Total interest and
related portfolio
income............. $27,678 $25,974 $22,546 $21,321 $36,897 $25,984 $25,111 $24,911 $21,399
Portfolio income
before realized and
unrealized gains... 13,830 11,776 9,401 9,148 24,920 7,910 12,093 14,095 11,968
Net increase in net
assets resulting
from operations.... 18,580 16,631 14,906 14,476 32,065 13,216 17,146 18,296 12,646
Basic earnings per
common share....... 0.33 0.31 0.29 0.28 0.62 0.25 0.35 0.37 0.27
Diluted earnings per
common share....... 0.33 0.31 0.29 0.28 0.61 0.25 0.35 0.37 0.27
Net asset value per
common share(1).... 8.98 8.68 8.13 8.14 8.23 8.07 8.42 8.50 8.39
Dividends declared
per common share... 0.40 0.38 0.35 0.35 0.35 0.80(2) 0.31 0.30 0.30
</TABLE>

- -------------------------
(1) We determine net asset value per common share as of the last day of the
quarter. The net asset values shown are based on outstanding shares at the
end of each period, excluding common stock held in the Company's deferred
compensation trust.

(2) During the fourth quarter of 1997, the Company declared a quarterly dividend
of $0.61 per common share which included $0.34 per common share representing
the distribution of shares of Allied Capital Lending Corporation previously
held in Allied Capital Corporation's (old) portfolio. The Company also
declared an annual extra distribution of $0.02 per common share, and a
special distribution of previously undistributed earnings of $0.17 per
common share in conjunction with the merger.

WHERE YOU CAN FIND
ADDITIONAL INFORMATION

We have filed with the Securities and Exchange Commission (the
"Commission") a registration statement and related exhibits under the Securities
Act of 1933, as amended (the "Securities Act"). The registration statement
contains additional information about us and the registered securities being
offered by this prospectus. You may inspect the registration statement and the
exhibits without charge at the Securities and Exchange Commission at 450 Fifth
Street, NW, Washington, DC 20549. You may obtain copies from the Commission at
prescribed rates.

We file annual, quarterly and special reports, proxy statements and other
information with the Commission. You can inspect, without charge, at the public
reference facilities of the Commission at 450 Fifth Street, NW, Washington, DC
20549; Seven World Trade Center, New York, New York 10048; and 500 West Madison
Street, Chicago, Illinois 60661. The Commission also maintains a web site at
http://www.sec.gov that contains reports, proxy statements and other information
regarding public companies, including our Company. You can also obtain copies of
these materials from the public reference section of the Commission at 450 Fifth
Street, NW, Washington, DC 20549, at prescribed rates. Please call the
Commission at 1-800-SEC-0330 for further information on the public reference
room. You can also inspect reports and other information we file at the offices
of the Nasdaq Stock Market, 1735 K Street, NW, Washington, DC 20006.
6
<PAGE> 11

RISK FACTORS

Investing in the Company involves a number of significant risks and other
factors relating to the structure and investment objective of the Company. As a
result, there can be no assurance that the Company will achieve its investment
objective. In addition to the information contained in this prospectus, you
should consider carefully the following information before making investments in
the shares.

LENDING TO SMALL, PRIVATELY OWNED COMPANIES INVOLVES A HIGH DEGREE OF RISK.

Our portfolio consists primarily of loans to small, privately owned
companies. There is generally no publicly available information about these
companies, and we rely on the diligence of our employees and agents to obtain
information in connection with the Company's investment decisions. Typically,
small businesses depend on the management talents and efforts of one person or a
small group of persons for their success. The death, disability or resignation
of these persons could have a material adverse impact on such a company. In
addition, small businesses frequently have smaller product lines and market
shares than their competition. Small companies may be more vulnerable to
customer preferences, market conditions and economic downturns and often need
substantial additional capital to expand or compete. Small companies may also
experience substantial variations in operating results, and frequently have
highly leveraged capital structures. Such factors can severely effect the return
on, or the recovery of, our investment in such businesses. Loans to small
businesses, therefore, involve a high degree of business and financial risk,
which can result in substantial losses and accordingly should be considered
speculative.

OUR BORROWERS MAY DEFAULT ON THEIR PAYMENTS.

We invest in and lend to small businesses that may have limited financial
resources and that may be unable to obtain financing from traditional sources.
Our borrowers may not meet net income, cash flow and other coverage tests
typically imposed by bank lenders. Numerous factors may affect a borrower's
ability to repay its loan, including the failure to meet its business plan, a
downturn in its industry or negative economic conditions. A deterioration in a
borrower's financial condition and prospects may be accompanied by deterioration
in the collateral for the loan. We also make unsecured, subordinated loans or
invest in equity securities, which may involve a higher degree of risk.

OUR PORTFOLIO OF INVESTMENTS IS ILLIQUID.

We acquire most of our loans and equity securities directly from small
companies. Our portfolio of loans and equity securities are and will be subject
to restrictions on resale or otherwise have no established trading market. The
illiquidity of most of our portfolio may adversely affect our ability to dispose
of loans and securities at times when it may be advantageous for us to liquidate
such investments.

WE INVEST IN NON-INVESTMENT GRADE CMBS.

The commercial mortgage-backed securities ("CMBS") in which we invest are
non-investment grade, which means that nationally recognized statistical rating
organizations rate them below the top four investment-grade rating categories
(e.g., "AAA" through "BBB"). Non-investment grade securities usually pay a
higher interest rate than do investment-grade bonds, but with the higher return
comes greater risk. Non-investment grade securities are considered speculative,
and their capacity to pay principal and interest

7
<PAGE> 12

in accordance with the terms of their issue is not ensured. They tend to react
more to changes in interest rates than do higher-rated securities, have a higher
risk of default, tend to be less liquid, and may be more difficult to value.

OUR PORTFOLIO IS RECORDED AT FAIR VALUE AS DETERMINED BY THE BOARD OF DIRECTORS.

There is typically no public market for the loans and equity securities of
the small companies to which we make loans. As a result, our board of directors
estimates the value of these loans and equity securities. Unlike traditional
lenders, we do not establish reserves for anticipated loan losses. Instead, we
adjust quarterly the valuation of our portfolio to reflect the board of
directors' estimate of the current realizable value of our loan portfolio.
Without a readily ascertainable market value, the estimated value of our
portfolio of loans and equity securities may differ significantly from the
values that would be placed on the portfolio if there existed a ready market for
the loans and equity securities. Any changes in estimated net asset value are
recorded in the Company's statement of operations as "Net unrealized gains
(losses)."

WE BORROW MONEY WHICH MAY INCREASE THE RISK OF INVESTING IN OUR COMPANY.

We borrow from, and issue senior debt securities to, banks and other
lenders. Lenders of these senior securities have fixed dollar claims on our
consolidated assets which are superior to the claims of our common shareholders.

Borrowings, also known as leverage, magnifies the potential for gain and
loss on amounts invested and, therefore, increases the risks associated with
investing in our securities. If the value of our consolidated assets increases,
then leveraging would cause the net asset value attributable to the Company's
common stock to increase more sharply than it would have had we not leveraged.
Conversely, if the value of our consolidated assets decreases, leveraging would
cause net asset value to decline more sharply than it otherwise would have had
we not leveraged. Similarly, any increase in our consolidated income in excess
of consolidated interest payable on the borrowed funds would cause our net
income to increase more than it would without the leverage, while any decrease
in our consolidated income would cause net income to decline more sharply than
it would have had we not borrowed. Such a decline could negatively affect our
ability to make common stock dividend payments, and, if asset coverage for a
class of senior security representing indebtedness declines to less than 200%,
we may be required to sell a portion of our investments when it is
disadvantageous to do so. Leverage is generally considered a speculative
investment technique.

As of March 31, 1999, the Company's debt as a percentage of total
liabilities and shareholders' equity was 43%. Our ability to achieve our
investment objective may depend in part on our continued ability to maintain a
leveraged capital structure by borrowing from banks or other lenders on
favorable terms. There can be no assurance that we will be able to maintain such
leverage.

At March 31, 1999, the Company had $410.7 million of outstanding
indebtedness, bearing a weighted annual interest rate of 7.2%. In order for us
to cover annual interest payments on indebtedness, we must achieve annual
returns of at least 3.1% on our portfolio.

Illustration. The following table illustrates the effect of leverage on
returns from an investment in our common stock assuming various annual returns,
net of expenses. The calculations in the table below are hypothetical and actual
returns may be higher or lower than those appearing below.

8
<PAGE> 13

ASSUMED RETURN ON THE COMPANY'S PORTFOLIO
(NET OF EXPENSES)

<TABLE>
<CAPTION>
-20% -10% -5% 0% 5% 10% 20%
------ ------ ------ ----- ---- ----- -----
<S> <C> <C> <C> <C> <C> <C> <C>
Corresponding return to shareholder(1)... -42.5% -24.1% -14.9% -5.7% 3.5% 12.7% 31.1%
</TABLE>

- -------------------------

(1) The calculation assumes (i) $961.4 million in total assets, (ii) an average
cost of funds of 7.2%, (iii) $410.7 million in debt outstanding and (iv)
$522.9 million of shareholders' equity.

CHANGES IN INTEREST RATES MAY AFFECT OUR PROFITABILITY.

Because we borrow money to make investments, our income is materially
dependent upon the "spread" between the rate at which we borrow funds and the
rate at which we loan these funds. In periods of sharply rising interest rates,
our cost of funds would increase and could reduce or eliminate the spread. We
use a combination of long-term and short-term borrowings to finance our lending
activities. We may use interest rate risk management techniques in an effort to
limit our exposure to interest rate fluctuations. Such techniques may include
various interest rate hedging activities to the extent permitted by the 1940
Act. There can be no assurance that we can maintain a positive net interest
spread or that a significant change in market interest rates will not have a
material adverse effect on our profitability.

BECAUSE WE MUST DISTRIBUTE INCOME, WE WILL CONTINUE TO NEED ADDITIONAL CAPITAL.

We will continue to need capital to fund loans. Historically, we have
borrowed from financial institutions and have issued equity securities. A
reduction in the availability of funds from financial institutions could have a
material adverse effect on the Company. We must distribute at least 90% of our
net operating income other than net realized long-term capital gains to our
stockholders to maintain our regulated investment company ("RIC") status. As a
result such earnings will not be available to fund loan originations. We expect
to borrow from financial institutions and sell additional equity securities. If
we fail to obtain funds from such sources or from other sources to fund our
loans, it could have a material adverse effect on the Company's financial
condition and our results. In addition, as a BDC, we are generally required to
maintain a ratio of at least 200% of total assets to total borrowings, which may
restrict our ability to borrow in certain circumstances.

OUR PORTFOLIO MAY NOT PRODUCE CAPITAL GAINS.

Mezzanine loans are typically structured as debt securities with a
relatively high fixed rate of interest and with an equity feature such as
conversion rights, warrants or options. As a result, mezzanine loans will
generate interest income from the time they are made, and may also produce a
realized gain, from an accompanying equity feature. We cannot be sure that our
portfolio will generate a current return or capital gains.

LOSS OF PASS-THROUGH TAX TREATMENT WOULD SUBSTANTIALLY REDUCE NET ASSETS AND
INCOME AVAILABLE FOR DIVIDENDS.

The Company qualifies as a RIC. If we meet certain diversification and
distribution requirements, the Company qualifies for pass-through tax treatment.
The Company would cease to qualify for pass-through tax treatment if it were
unable to comply with these requirements, or if it ceased to qualify as a BDC
under the 1940 Act. We also could be subject to a 4% excise tax (and, in certain
cases, corporate level income tax) if we fail to make certain distributions. If
the Company fails to qualify as a RIC, the Company would

9
<PAGE> 14

become subject to federal income tax as if it were an ordinary corporation,
which would substantially reduce our net assets and the amount of income
available for distribution to our shareholders.

WE OPERATE IN A COMPETITIVE MARKET.

We compete for investments with many other companies and individuals, some
of whom have greater resources than we do. Increased competition would make it
more difficult for us to purchase or originate loans at attractive prices. As a
result of this competition, sometimes we may be precluded from making otherwise
attractive investments.

WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT.

We are regulated by the Commission and the SBA. In addition, changes in the
laws or regulations that govern BDCs, RICs, real estate investment trusts
("REITs"), SBICs and SBLCs may significantly affect our business. Laws and
regulations may be changed from time to time, and the interpretations of the
relevant laws and regulations also are subject to change. Any change in the law
or regulations that govern our business could have a material impact on the
Company or its operations.

QUARTERLY RESULTS MAY FLUCTUATE FROM QUARTER TO QUARTER.

The Company's quarterly operating results could fluctuate due to a number
of factors. These factors include, among others, the completion of a
securitization transaction in a particular calendar quarter, variations in the
loan origination volume, variation in timing of loan prepayments, variations in
and the timing of the recognition of realized and unrealized gains or losses,
the degree to which we encounter competition in our markets and general economic
conditions. As a result of these factors, you should not rely on quarterly
results to be indicative of the Company's performance in future quarters.

10
<PAGE> 15

THE COMPANY

Our company is principally engaged in lending to and investing in private
small and medium-sized businesses. The Company is organized in the state of
Maryland and is an internally managed closed-end management investment company
that has elected to be regulated as a business development company (as defined
above, a "BDC") under the 1940 Act.

We have two wholly owned subsidiaries that have also elected to be
regulated as BDCs. Allied Investment Corporation ("Allied Investment") is
licensed by the Small Business Administration ("SBA") as a Small Business
Investment Company ("SBIC"). Allied Capital SBLC Corporation ("Allied SBLC") is
licensed by the SBA as a Small Business Lending Company ("SBLC") and is a
participant in the SBA Section 7(a) Guaranteed Loan Program. In addition, we
have a real estate investment trust subsidiary, Allied Capital REIT, Inc.
("Allied REIT").

Our executive offices are located at 1919 Pennsylvania Avenue, NW,
Washington, DC 20006 and our telephone number is (202) 331-1112. In addition, we
maintain regional offices in Chicago and San Francisco, and offices focused on
small business lending in Detroit, Atlanta, and Philadelphia. We also have an
office in Frankfurt, Germany.

USE OF PROCEEDS

We anticipate that substantially all of the net proceeds of any offering of
shares will be used, as described above, within six months, and in any event
within two years. Pending investment, we intend to invest the net proceeds of
any offering of shares in time deposits, income-producing securities with
maturities of three months or less that are issued or guaranteed by the federal
government or an agency of the federal government, and high quality debt
securities maturing in one year or less from the time of investment. Our ability
to achieve our investment objective may be limited to the extent that the net
proceeds of any offering, pending full investment, are held in time deposits and
other short-term instruments.

11
<PAGE> 16

PRICE RANGE OF COMMON STOCK AND DIVIDENDS

Our common stock is traded on the Nasdaq National Market under the symbol
"ALLC." The following table lists the high and low closing sales prices for the
Company's stock in 1998 and 1999 and for Allied Capital Lending Corporation's
stock, the predecessor company to the Company, in 1997. The stock quotations are
interdealer quotations and do not include markups, markdowns or commissions. On
, 1999, the last reported closing sale price of the common stock
was $ per share.

<TABLE>
<CAPTION>
CLOSING SALE PRICE
------------------
HIGH LOW
------- -------
<S> <C> <C>
ALLIED CAPITAL LENDING CORPORATION
YEAR ENDED DECEMBER 31, 1997
First Quarter............................. $17.000 $14.875
Second Quarter............................ 16.625 13.875
Third Quarter............................. 16.750 14.500
Fourth Quarter............................ 22.750 15.750
ALLIED CAPITAL CORPORATION
YEAR ENDED DECEMBER 31, 1998
First Quarter............................. $27.688 $21.000
Second Quarter............................ 29.000 21.750
Third Quarter............................. 24.813 14.938
Fourth Quarter............................ 18.875 12.500
YEAR ENDING DECEMBER 31, 1999
First Quarter............................. $20.250 $16.500
Second Quarter (through ,
1999)..................................
</TABLE>

Allied Capital Lending Corporation's common stock historically traded at
prices in excess of its net asset value. Our common stock continues to trade in
excess of net asset value. There can be no assurance, however, that we will
maintain a premium to net asset value.

We pay quarterly dividends to stockholders. The Company has indicated that
it expects to distribute four regular quarterly dividends of $0.40 per share
during 1999, for total dividends of at least $1.60 per share for 1999. The
amount of our quarterly dividends is determined by the board of directors and is
based upon an estimate of annual taxable income. The Company's current dividend
policy is to distribute substantially all of its taxable income, including
capital gains, annually. See "Taxation." We cannot assure that we will achieve
investment results or maintain a tax status that will permit any particular
level of dividend payment.

Our credit facilities limit our ability to declare dividends if we default
under certain provisions.

12
<PAGE> 17

MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The information contained in this section should be read in conjunction
with the Selected Consolidated Financial Data and the Company's Consolidated
Financial Statements and Notes thereto.

OVERVIEW

The Company's primary business is investing in and lending to private small
and medium-sized businesses in three areas: mezzanine finance, commercial real
estate finance, including the purchase of commercial mortgage-backed securities
("CMBS"), and 7(a) lending.

The Company's earnings depend primarily on the level of interest and
related portfolio income and net realized and unrealized gain income earned on
the Company's investment portfolio after deducting interest paid on borrowed
capital and operating expenses. Interest income results from the stated interest
rate earned on a loan, the amortization of loan origination points and original
issue discount, and the amortization of any market discount arising from
purchased loans. The level of interest income is directly related to the balance
of the investment portfolio multiplied by the effective yield on the portfolio.
The Company's ability to generate interest income is dependent on economic,
regulatory and competitive factors that influence interest rates and loan
originations, and the Company's ability to secure financing for its investment
activities.

The total portfolio at value was $885.8 at March 31, 1999 and $800.3
million, $697.0 million and $607.4 million at December 31, 1998, 1997 and 1996,
respectively. During the three months ended March 31, 1999, the Company
originated investments totaling $159.4 million and received repayments of $37.3
million and sold loans of $40.5 million. As a result, the total portfolio
increased by 10.7% from December 31, 1998 to March 31, 1999. The portfolio
increased approximately 15% for each of the years ended December 31, 1998, 1997
and 1996.

<TABLE>
<CAPTION>
AT AT DECEMBER 31,
MARCH 31, -------------------
ASSET COMPOSITION 1999 1998 1997 1996
----------------- --------- ---- ---- -----
<S> <C> <C> <C> <C>
Mezzanine Investments................... 42% 46% 25% 27%
Commercial Mortgage Loans............... 22% 27% 56% 52%
Commercial Mortgage-Backed Securities... 21% 13% -- --
SBA 7(a) Loans.......................... 6% 7% 5% 6%
Cash and Other Assets................... 9% 7% 14% 15%
---- ---- ---- ----
100% 100% 100% 100%
==== ==== ==== ====
</TABLE>

MEZZANINE

Mezzanine loans, debt securities and equity interests were $407.5 million,
$388.6 million, $207.7 million and $191.2 million at March 31, 1999 and December
31, 1998, 1997 and 1996, respectively. The effective yield on the mezzanine
loans and debt securities was 14.0%, 14.6%, 12.6%, and 13.2% at March 31, 1999
and December 31, 1998, 1997 and 1996, respectively. Mezzanine loan originations
and purchases were $39.4 million and $37.8 million for the three months ended
March 31, 1999 and 1998 and, $236.0 million, $66.7 million and $66.2 million for
the years ended December 31, 1998,

13
<PAGE> 18

1997 and 1996, respectively. Mezzanine repayments and sales were $24.6 million
and $13.8 million for the three months ended March 31, 1999 and 1998 and $41.3
million, $64.9 million, and $67.3 million for the years ended December 31, 1998,
1997 and 1996, respectively.

COMMERCIAL MORTGAGE-BACKED SECURITIES

Commercial Mortgage-Backed Securities (CMBS) were $200.8 million and $113.7
million at March 31, 1999 and December 31, 1998. The portfolio at March 31, 1999
consists of $116.3 million of purchased Subordinated CMBS and $84.5 million of
Residual CMBS retained from a $295 million asset securitization the Company
completed on January 30, 1998. During the first quarter of 1999, the Company
purchased for a price of $88.0 million, Subordinated CMBS with a face value of
$177.9 million. As of March 31, 1999 and December 31, 1998, the estimated yield
to maturity on the Subordinated CMBS and the Residual CMBS was 14.6% and 10.1%
and 15.0% and 9.7%, respectively. As of March 31, 1999 and December 31, 1998,
the weighted average yield on the entire CMBS portfolio was 12.7% and 11.2%,
respectively.

Since the fourth quarter of 1998, few commercial lenders have had the
liquidity to participate in the purchase of these bonds. The Company will
continue to bid on similar CMBS offerings. The purchases of the Subordinated
CMBS have had, and will continue to have, the full scrutiny of the Company's
stringent underwriting processes. The Company re-underwrites the majority of the
loans securing the bonds, including determining its own assessment of cash flow
available for debt service and appraisal value, and visits most of the
collateral properties.

COMMERCIAL MORTGAGE LOANS

Commercial mortgage loans were $210.9 million at March 31, 1999 and $233.2
million, $447.2 million and $373.7 million at December 31, 1998, 1997 and 1996,
respectively. The weighted average current stated interest rate on the
commercial mortgage loan portfolio at March 31, 1999 was 9.8% and at December
31, 1998, 1997 and 1996 was 9.7%, 9.6% and 10.3%, respectively. The weighted
average yield on the commercial mortgage loan portfolio was 10.4% at March 31,
1999 and 10.4%, 11.4% and 13.4% at December 31, 1998, 1997 and 1996,
respectively. The effective yield on the commercial mortgage loan portfolio is
higher than the stated interest rate due to the amortization of market discount
on purchased loans and original issue discount.

During the first quarter of 1999, the Company combined its commercial real
estate loan origination for sale operations with its SBA lending operations in
order to increase its competitiveness in the small business lending area, and in
order to increase the premiums earned on loans originated for sale. Small
commercial real estate loans originated for sale in the first quarter of 1999
totaled $13.6 million. Sales of small commercial real estate loans in the first
quarter of 1999 totaled $31.4 million. Sales in the first quarter of 1999
included loans totaling $17 million that were originated or purchased over
several years, and were sold at par.

The commercial mortgage loan portfolio decreased by 48% and increased by
20% and 35% for the years ended December 31, 1998, 1997 and 1996, respectively.
During the first quarter of 1998 the Company decreased its commercial loan
portfolio through the securitization of $295 million in commercial real estate
loans. Commercial mortgage loan originations and purchases were $198.6 million,
$249.0 million and $176.3 million, and repayments were $96.7 million, $154.5
million and $87.5 million for 1998, 1997 and 1996, respectively.

14
<PAGE> 19

SBA 7(a) LOANS

The SBA 7(a) loan portfolio was $58.3 million at March 31, 1999 and $56.3
million, $40.7 million and $42.1 million at December 31, 1998, 1997 and 1996,
respectively. SBA 7(a) loan originations were $18.4 million and $15.7 million
for the three months ended March 31, 1999 and 1998, respectively, and $57.7
million, $49.2 million and $40.8 million for the years ended December 31, 1998,
1997 and 1996, respectively. Sales of the guaranteed portions of SBA 7(a) loans
were $13.0 million and $9.7 million for the three months ended March 31, 1999
and 1998, respectively and $37.0 million, $43.4 million and $25.0 million for
the years ended December 31, 1998, 1997 and 1996, respectively. SBA 7(a) loans
are originated with variable interest rates priced at spreads ranging from 1.75%
to 2.75% over the prime lending rate.

RESULTS OF OPERATIONS

COMPARISON OF THREE MONTHS ENDED MARCH 31, 1999 AND 1998

Net increase in net assets resulting from operations (NIA) was $18.6
million, or $0.33 per share, and $32.1 million, or $0.61 per share, for the
three months ended March 31, 1999 and 1998, respectively. NIA results from total
interest and related portfolio income earned, less total expenses incurred in
the operations of the Company, plus net realized and unrealized gains or losses.
The NIA for the three months ended March 31, 1998 also includes a gain of $14.8
million, or $0.28 per share, resulting from a commercial mortgage loan
securitization transaction that was completed in January 1998.

Total interest and related portfolio income was $27.7 million and $36.9
million for the three months ended March 31, 1999 and 1998, respectively. Total
interest and related portfolio income is primarily a function of the level of
interest income earned and the balance of portfolio assets. In addition, total
interest and related portfolio income includes net premiums from loan
dispositions, prepayment premiums, and advisory fee and other income. 1998 total
interest and related portfolio income includes a gain on sale of $14.8 million
resulting from a commercial mortgage loan securitization transaction that was
completed in January 1998. Excluding this gain, total interest and related
portfolio income was $22.1 million for the three months ended March 31, 1998.
Thus excluding the 1998 gain on sale, total interest and related portfolio
income increased in the first quarter of 1999 as compared to the first quarter
of 1998 by 25.3%.

Interest income totaled $24.7 million and $19.5 million for the three
months ended March 31, 1999 and 1998, respectively. Interest income increased
$5.2 million or 27% compared to the same period in the prior year. The increase
in interest income earned results primarily from changes in the amount of
interest bearing investments outstanding during the periods presented. The
Company's investment portfolio, excluding equity interests in portfolio
companies, increased by 58% to $829.9 million at March 31, 1999 from $524.8
million at March 31, 1998. The weighted average yield on the interest bearing
investments in the portfolio at March 31, 1999 was 12.6% as compared to 12.4% at
March 31, 1998.

Net premiums from loan dispositions were $1.9 million and $1.3 million for
the three months ended March 31, 1999 and 1998, respectively. Included in net
premiums from loan dispositions are premiums from loan sales and premiums
received on the early repayment of loans. Premiums from loan sales were $1.8
million and $0.8 million for the three months ended March 31, 1999 and 1998,
respectively. This premium income results primarily from the premium paid by
purchasers of the guaranteed portion of the

15
<PAGE> 20

Company's SBA 7(a) loans into the secondary market and commercial real estate
loans sold to third parties, less the origination costs associated with the
loans sold. Prepayment premiums were $0.1 million and $0.5 million for the three
months ended March 31, 1999 and 1998, respectively. While the scheduled maturity
of mezzanine and commercial mortgage loans ranges from five to ten years, it is
not unusual for the Company's borrowers to refinance or pay off their debts to
the Company ahead of schedule. Because the Company seeks to finance primarily
seasoned, performing companies, such companies at times can secure lower cost
financing as their balance sheets strengthen, or as more favorable interest
rates become available. Therefore, the Company generally structures its loans to
require a prepayment premium for the first three to five years of the loan.

Investment advisory fees and other income were $1.1 million and $1.2
million for the three months ended March 31, 1999 and 1998, respectively.
Investment advisory fees are received from the private funds managed by the
Company, primarily from a fund managed in Germany.

Total operating expenses were $12.1 million and $10.2 million for the three
months ended March 31, 1999 and 1998, respectively. Operating expenses include
interest on indebtedness, salaries and employee benefits, and general and
administrative expenses.

The Company's single largest expense is interest on indebtedness, which
totaled $6.4 million and $4.6 million for the three months ended March 31, 1999
and 1998, respectively. Interest expense increased $1.8 million, or 38%,
compared to the same period in the prior year. The increase is attributable to
an increase in borrowings by the Company and its subsidiaries under various
credit facilities. The Company's total borrowings were $410.7 million and $202.2
million at March 31, 1999 and 1998, respectively. Average outstanding
indebtedness for the quarters ended March 31, 1999 and 1998 was $353.9 million
and $246.0 million, respectively. The Company's weighted average interest cost
on outstanding borrowings at March 31, 1999 and 1998 was 7.2% and 7.6%,
respectively.

Salaries and employee benefits totaled $3.4 million and $2.9 million for
the three months ended March 31, 1999 and 1998, respectively. Total employees
were 108 and 90 at March 31, 1999 and 1998, respectively. The increase in
salaries and employee benefits reflects the increase in total employees,
combined with wage increases and the experience level of employees hired. The
Company was an active recruiter throughout 1998 and in the first quarter of 1999
for experienced investment and operational personnel, and the Company will
continue to actively recruit and hire new professionals in 1999 to support
anticipated portfolio growth.

General and administrative expenses include the leases for the Company's
headquarters in Washington, DC, and its offices in Chicago and San Francisco. In
addition the Company maintains offices focused on small business lending in
Detroit, Atlanta and Philadelphia. General and administrative expenses also
include travel costs, stock record expenses, directors' fees, legal and
accounting fees and various other expenses. General and administrative expenses
totaled $2.4 million and $2.8 million for the three months ended March 31, 1999
and 1998, respectively. The decrease in general and administrative expenses was
partially due to certain post-Merger integration expenses incurred in the first
quarter of 1998, totaling $0.2 million. The post-Merger integration expenses
included primarily the costs of legal and accounting advice as well as the use
of certain outside consultants. The remaining decrease is the result of
differences that result from the timing of expenses recognized in 1998.

16
<PAGE> 21

Operating expenses excluding interest on indebtedness represented
approximately 0.63% and 0.77% of the Company's average assets for the three
months ended March 31, 1999 and 1998, respectively. For the three months ended
March 31, 1999 and 1998, the operating expenses excluding interest on
indebtedness as a percent of total interest and related portfolio income less
interest expense plus net realized and unrealized capital gains was 22% and 14%,
respectively. For the years ended December 31, 1998, 1997 and 1996 this ratio
was 22%.

The cut-off award and formula award totaled $1.8 million, or $0.03 per
share, for the three months ended March 31, 1999 and 1998.

The cut-off award expense totaled $0.2 million for the three months ended
March 31, 1999 and 1998. The cut-off award was designed to cap the appreciated
value in unvested options at the Merger announcement date in order to set the
foundation to balance option awards upon the Merger. The cut-off award will only
be payable if the award recipient is employed by the Company on a future vesting
date. Total cut-off award that will vest in 1999 is estimated at $0.8 million.

The formula award expense totaled $1.6 million for the three months ended
March 31, 1999 and 1998. The formula award was designed as an incentive
compensation program that would replace canceled stock options that were
cancelled as a result of the Company's 1997 Merger and would balance share
ownership among key officers. The formula award vests over a three-year period,
on the anniversary date of the Merger, beginning on December 31, 1998. Assuming
all officers who received a formula award remain with the Company over the
remaining vesting period, the Company will expense the remaining formula award
during 1999 and 2000 in an annual amount of approximately $6.4 million.

Net realized gains were $0.4 million and $6.4 million for the three months
ended March 31, 1999 and 1998, respectively. These gains resulted from the sale
of equity securities associated with certain mezzanine and commercial mortgage
loans and the realization of unamortized discount resulting from the early
repayment of mezzanine and commercial mortgage loans, offset by losses on
investments.

Realized gains totaled $0.8 million and $6.4 million for the three months
ended March 31, 1999 and 1998, respectively. Realized gains during 1999
primarily resulted from transactions involving three portfolio companies. Gains
resulting from investments in these three companies totaled $0.7 million.
Realized losses totaled $0.3 million for the three months ended March 31, 1999.
There were no realized losses during the quarter ended March 31, 1998. Realized
losses during 1999 resulted primarily from the full or partial liquidation of
several portfolio investments. Losses realized in 1999 had been recognized in
NIA over time as unrealized depreciation when the Company determined that the
respective portfolio security's value had become impaired. Thus, the Company
reversed previously recorded unrealized depreciation totaling $0.3 million in
1999 when the related losses were realized.

The Company recorded net unrealized gains of $4.3 million and $0.7 million
for the three months ended March 31, 1999 and 1998, respectively. Net unrealized
gains for 1999 consisted of valuation changes resulting from the Board of
Directors' valuation of the Company's assets and the effect of reversals of net
unrealized appreciation resulting from net realized gains. At March 31, 1999,
net unrealized appreciation in the portfolio totaled $6.7 million, and was
composed of unrealized appreciation of $33.3 million resulting primarily from
appreciated equity interests in portfolio companies, and unrealized

17
<PAGE> 22

depreciation of $26.6 million resulting primarily from underperforming loan and
equity investments in the portfolio. At March 31, 1998, net unrealized
appreciation in the portfolio totaled $2.0 million and was composed of
unrealized appreciation of $25.1 million and unrealized depreciation of $23.1
million.

The Company employs a standard grading system for the entire portfolio.
Grade 1 is used for those investments from which a capital gain is expected.
Grade 2 is used for investments performing in accordance with plan. Grade 3 is
used for investments that require closer monitoring; however, no loss of
interest or principal is expected. Grade 4 is used for investments for which
some loss of contractually due interest is expected, but no loss of principal is
expected. Grade 5 is used for investments for which some loss of principal is
expected and the investment is written down to net realizable value. During
1998, the Company began to grade its commercial mortgage and 7(a) loan
portfolios using the same grading system used for its mezzanine loan portfolio,
so that the Company's entire portfolio would have a uniform grading system.
Prior to this, the commercial real estate portfolio used a different grading
system and the 7(a) loan portfolio was not graded.

At March 31, 1999, the Company's portfolio was graded as follows:

<TABLE>
<CAPTION>
PORTFOLIO BY GRADE
------------------ INVESTMENTS PERCENTAGE OF
GRADE AT VALUE TOTAL PORTFOLIO
----- ------------- ---------------
(IN MILLIONS)
<S> <C> <C>
1............................................ $112.7 12.7%
2............................................ 700.6 79.1
3............................................ 39.7 4.5
4............................................ 19.8 2.2
5............................................ 13.0 1.5
------ -----
$885.8 100.0%
====== =====
</TABLE>

Grade 5 mezzanine investments totaled $7.7 million at value at March 31,
1999, or 0.9%, of the Company's total portfolio based on the valuation of the
Board of Directors. The value of these Grade 5 mezzanine investments has been
reduced from an aggregate cost of $25.7 million in order to reflect the
Company's estimate of the net realizable value of these investments upon
disposition. This reduction in value has been recorded previously as unrealized
depreciation over several years in the Company's earnings. The Company continues
to follow its historical practices of working with a troubled portfolio company
in order to recover the maximum amount of the Company's investment, but records
unrealized depreciation for the expected full amount of the potential exposure
when such exposure is identified. Grade 5 mezzanine investments at December 31,
1998 totaled $6.4 million at value, or 0.8%, of the Company's total portfolio.

At March 31, 1999, Grade 5 commercial mortgage loans totaled $0.1 million
at value. The value of these Grade 5 loans approximates cost because of the
estimated value of the underlying collateral securing the loans. Grade 5
commercial mortgage loans at December 31, 1998 totaled $0.1 million at value.

Grade 5 SBA 7(a) loans totaled $5.2 million at value at March 31, 1999, and
have been reduced from an aggregate cost basis of $6.7 million. Grade 5 SBA 7(a)
loans at December 31, 1998 totaled $6.3 million at value.

For the total portfolio, loans greater than 120 days delinquent were $20.0
million at value at March 31, 1999, or 2.3% of the total portfolio. Included in
this category are loans

18
<PAGE> 23

valued at $8.4 million that are fully secured by real estate. Loans greater than
120 days delinquent generally do not accrue interest. Loans greater than 120
days delinquent at December 31, 1998, were $13.7 million at value, or 1.7% of
the total portfolio.

Because the Company has elected to be taxed as a regulated investment
company ("RIC") under Subchapter M of the Code, the Company is not taxed on its
investment company taxable income and realized capital gains, to the extent that
such income and gains are distributed to shareholders. The Company's dividend
policy currently is to annually distribute substantially all of its taxable
income, including net capital gains, if any. Annual tax distributions may differ
from NIA for the fiscal year due to timing differences in the recognition of
income and expenses, returns of capital and net unrealized appreciation or
depreciation, which are not included in taxable income.

In order to maintain its RIC status, the Company must, in general, (1)
derive at least 90% of its gross income from dividends, interest and gains from
the sale of securities; (2) meet investment diversification requirements as
defined in the Code; and (3) distribute to shareholders at least 90% of its
investment company taxable income annually. The Company intends to take all
steps necessary to continue to meet the RIC qualifications. However, there can
be no assurance that the Company will continue to elect or qualify for such
treatment in future years.

Certain of the Company's credit facilities limit the Company's ability to
declare dividends, should the Company default under certain provisions of the
respective credit agreements.

The weighted average common shares outstanding used to compute basic
earnings per share were 56.8 million and 51.8 million for the three months ended
March 31, 1999 and 1998, respectively. The increases in the weighted average
shares reflect the issuance of new shares and the issuance of shares pursuant to
a dividend reinvestment plan.

All per share amounts included in management's discussion and analysis have
been computed using the weighted average shares used to compute diluted earnings
per share, which were 56.8 million and 52.1 million for the three months ended
March 31, 1999 and 1998, respectively.

COMPARISON OF FISCAL YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

Net increase in net assets resulting from operations (NIA) was $78.1
million, or $1.50 per share, $61.3 million, or $1.24 per share, and $54.9
million, or $1.17 per share, for the years ended December 31, 1998, 1997 and
1996, respectively. NIA results from total interest and related portfolio income
earned, less total expenses incurred in the operations of the Company, plus net
realized and unrealized gains or losses. NIA, as a percentage of average
shareholders' equity, which is also known as return on equity, was 17%, 15% and
14% for 1998, 1997 and 1996, respectively. NIA, excluding the formula and
cut-off awards in 1998, as a percentage of average shareholders' equity for 1998
was 18.8%. NIA, excluding Merger expenses, as a percentage of average
shareholders' equity for 1997 was 16%.

A key element of the Company's post-Merger strategy was to allocate more of
its capital resources to the Company's higher yielding mezzanine and 7(a)
lending activities and reduce its lower yielding commercial mortgage loan
portfolio. As a result, the Company completed a commercial mortgage loan
securitization transaction in January 1998, in order to effectively liquidate
$223 million of its lower yielding commercial mortgage loans. The Company
securitized $295 million in loans and received cash

19
<PAGE> 24

proceeds, net of costs, of $223 million. The Company retained a trust
certificate for its residual interest in mortgage securitization (the "Residual
CMBS") in the loan pool sold, and will receive interest income from this
Residual CMBS as well as receive the net spread of the interest earned on the
loans sold less the interest paid on the bonds over the life of the bonds (the
"Residual Securitization Spread").

The Company accounted for the securitization in accordance with Statement
of Financial Accounting Standards No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities." As a result,
the Company recorded a gain of $14.8 million, or $0.28 per share, net of the
costs of the securitization and the cost of settlement of interest rate swaps.
The gain arises from the difference between the carrying amount of the loans and
the fair market value of the assets received (i.e., cash, Residual
Securitization Spread, Residual CMBS and a servicing asset). The Company will
continue to earn interest income from the Residual CMBS, and will receive the
actual net spread from the portion of the loans sold represented by the bonds
issued. As the net spread is received, a portion will be allocated to interest
income with the remainder applied to reduce the carrying amount of the Residual
Securitization Spread. The Residual CMBS and the Residual Securitization Spread
have been and will continue to be valued each quarter using updated prepayment,
interest rate and loss estimates. As of December 31, 1998, the mortgage loan
pool had an approximate weighted average stated interest rate of 9.4%. The value
of the Residual Securitization Spread of $10.7 million was determined based on a
constant prepayment rate of 7% and a discount rate of 12%. The value of the
Residual CMBS of $70.8 million was determined using a discount rate equal to the
average stated interest rate of the underlying mortgage loans. The Company
completed the securitization as a means to improve its liquidity for investment
in high yielding mezzanine and 7(a) loans. The Company does not anticipate
significant future securitization activity.

Total interest and related portfolio income was $106.7 million, $97.4
million and $84.9 million for the years ended December 31, 1998, 1997 and 1996,
respectively. Total interest and related portfolio income is primarily a
function of the level of interest income earned and the balance of portfolio
assets. In addition, total interest and related portfolio income includes
premiums from loan sales, prepayment premiums, and advisory fee and other
income.

Interest income totaled $79.9 million, $86.9 million and $77.5 million for
the years ended December 31, 1998, 1997 and 1996, respectively. Interest income
decreased 8% and increased 12% for 1998 and 1997, respectively. The decrease and
increase in interest income earned results primarily from changes in the amount
of loans outstanding during the periods presented. The Company's loan portfolio
decreased by 4% to $628.6 million at December 31, 1998 from $655.8 million at
December 31, 1997, and the loan portfolio increased by 13% to $655.8 million at
December 31, 1997 from $580.9 million at December 31, 1996. During 1998, the
Company originated or purchased loans and other investments totaling $524.5
million. This increase was offset by the sale through securitization of $295
million in commercial mortgage loans, whole loan sales of commercial mortgage
loans of $44.0 million, and the sale of the guaranteed portion of 7(a) loans
totaling $37.0 million. In addition, the Company received loan repayments
totaling $138.1 million.

The Company's efforts to reduce its lower yielding commercial mortgage loan
portfolio in 1998 had the effect of reducing gross interest income in 1998 when
compared to 1997. The reduction in this portfolio, however, has increased the
overall weighted average yield on the portfolio, and should have the impact of
increasing interest income

20
<PAGE> 25

prospectively, as well as increasing the Company's overall return on assets net
of interest expense and return on equity capital. The weighted average yield on
the total loan portfolio at December 31, 1998 was 12.5%, as compared to 11.7%
and 13.1% at December 31, 1997 and 1996, respectively.

Net premiums from loan dispositions were $6.0 million, $7.3 million and
$4.2 million for the years ended December 31, 1998, 1997 and 1996, respectively.
Included in net premiums from loan dispositions are premiums from loan sales and
premiums received on the early repayment of loans. Premiums from loan sales were
$3.8 million, $3.2 million and $2.6 million for the years ended December 31,
1998, 1997 and 1996, respectively. This premium income results primarily from
the cash gain on the sale of the guaranteed portion of the Company's SBA 7(a)
loans into the secondary market and commercial real estate loans sold to third
parties, less the origination costs associated with the loans sold.

Prepayment premiums were $2.2 million, $4.1 million and $1.6 million for
the years ended December 31, 1998, 1997 and 1996, respectively. Commercial
mortgage loan repayments of $154.5 million in 1997 were primarily responsible
for the large level of prepayment premiums experienced in 1997. While the
scheduled maturity of mezzanine and commercial mortgage loans ranges from five
to ten years, it is not unusual for the Company's borrowers to refinance or pay
off their debts to the Company ahead of schedule. Because the Company seeks to
finance primarily seasoned, performing companies, such companies at times can
secure lower cost financing as their balance sheets strengthen, or as more
favorable interest rates become available. Therefore, the Company generally
structures its loans to require a prepayment premium for the first three to five
years of the loan.

Investment advisory fees and other income were $6.1 million, $3.2 million
and $3.2 million for the years ended December 31, 1998, 1997 and 1996,
respectively. Investment advisory fees are received from the private funds
managed by the Company. Three of the Company's private, managed funds are no
longer making new investments, and are returning capital to their investors as
their assets pay off. In January 1998, the Company entered into an investment
advisory agreement with Kreditanstalt fur Wiederaufbau (KfW), the state-owned
public development bank of Germany, to manage a fund of approximately DM 160
million (approximately $95.4 million at December 31, 1998). For its services
related to sourcing, structuring, investing, monitoring and disposing of its
investments in small, private and medium-sized German businesses, the Company
will receive a 3% per annum fee on total committed capital, payable quarterly.
The increase in advisory fees and other income in 1998 is primarily the result
of the advisory fees earned from KfW of approximately $2.7 million.

Total operating expenses were $44.4 million, $51.3 million ($46.2 million
without Merger expenses) and $37.4 million for the years ended December 31,
1998, 1997 and 1996, respectively. Operating expenses include interest on
indebtedness, salaries and employee benefits, and general and administrative
expenses.

The Company's single largest expense is interest on indebtedness, which
totaled $20.7 million, $27.0 million and $20.3 million for the years ended
December 31, 1998, 1997 and 1996, respectively. Interest expense decreased 23%
for 1998 and increased 33% and 64% for 1997 and 1996, respectively. The
increases and decreases are attributable to increases and decreases in
borrowings by the Company and its subsidiaries under various credit facilities.
Again, the Company's efforts to decrease the commercial mortgage loan portfolio
during 1998 had the effect of reducing the overall level of the Company's
outstanding borrowings throughout the year. The Company's total borrowings were

21
<PAGE> 26

$334.4 million, $347.7 million and $275.0 million at December 31, 1998, 1997 and
1996, respectively. Total borrowings decreased 4% for 1998 and increased 26% and
37% in 1997 and 1996, respectively. The Company's weighted average interest cost
on outstanding borrowings at December 31, 1998, 1997 and 1996 was 7.5%, 7.3% and
7.6%, respectively.

Salaries and employee benefits totaled $11.8 million, $10.3 million and
$8.8 million for the years ended December 31, 1998, 1997 and 1996, respectively.
Total employees were 106, 80 and 66 at December 31, 1998, 1997 and 1996,
respectively. The increase in salaries and employee benefits reflects the
increase in total employees, combined with wage increases and the experience
level of employees hired. The Company was an active recruiter in 1998 for
experienced investment and operational personnel and the Company will continue
to actively recruit and hire new professionals in 1999 to support anticipated
portfolio growth.

General and administrative expenses include the lease for the Company's
headquarters in Washington, DC, leases established in 1997 for the Company's
offices in Chicago and San Francisco, leases established in 1998 for the
Company's new offices in Atlanta and Detroit, travel costs, stock record
expenses, directors' fees, legal and accounting fees and various other expenses.
General and administrative expenses totaled $11.9 million, $9.0 million and $8.3
million, respectively, for the years ended December 31, 1998, 1997 and 1996. The
increase in general and administrative expenses was partially due to twelve full
months of costs associated with the two new offices that were established in the
third and fourth quarters of 1997.

In 1997, the Company incurred Merger expenses totaling $5.2 million, which
consisted primarily of investment banking fees of $3.1 million, legal fees of
$1.0 million and costs associated with the solicitation of proxies of
approximately $0.6 million.

Total operating expenses excluding interest on indebtedness and Merger
expenses represented approximately 2.9%, 2.5% and 2.6% of the Company's average
assets for the years ended December 31, 1998, 1997 and 1996, respectively.

During 1998, the Company began to expense a portion of the formula and
cut-off awards that were established in connection with the Merger. Prior to the
Merger, each of the predecessor companies had a stock option plan (the "Old
Plans"). In preparation for the Merger, the Compensation Committees of the
predecessor companies determined that the Old Plans should be terminated upon
the Merger, so that the new merged Company would be able to develop a new
incentive compensation plan for all officers and directors with a single equity
security. The existence of the Old Plans had resulted in certain inequities in
option grants among the various officers of the predecessor companies simply
because of the differences in the underlying equity securities.

To balance stock option awards among the employees, and to account for the
deviations caused by the existence of five plans supported by five different
publicly traded stocks, the Company developed two special awards to be granted
in lieu of options under the Old Plans that would be foregone upon the
cancellation of the Old Plans.

CUT-OFF AWARD. The first award established a cut-off dollar amount as of
August 14, 1997 (the Merger announcement date) that would be computed for all
outstanding, but unvested options that would be canceled as of the date of the
Merger. The cut-off award was designed to cap the appreciated value in unvested
options at the Merger announcement date in order to set the foundation to
balance option awards upon the Merger. The cut-off award was designed to be
equal to the difference between the market prices of the shares of stock
underlying the canceled options under the Old Plans at

22
<PAGE> 27

August 14, 1997, less the exercise prices of the options. The cut-off award was
computed to be $2.9 million in the aggregate and will be payable for each
canceled option as the canceled options would have vested. The cut-off award
will only be payable if the award recipient is employed by the Company on a
future vesting date. The cut-off award expense totaled $0.8 million, or $0.02
per share, for 1998.

FORMULA AWARD. The formula award was designed to compensate officers from
the point in time when their unvested options would cease to appreciate in value
pursuant to the mechanics of the cut-off award (i.e., August 14, 1997) up until
the time in which they would be able to receive option awards in the Company
after the Merger became effective. In the aggregate, the formula award equaled
6% of the difference between the combined aggregate market capitalizations of
the Predecessor Companies as of the close of the market on December 30, 1997,
and the combined aggregate market capitalizations of the Predecessor Companies
on August 14, 1997.

The formula award was designed as a long-term incentive compensation
program that would replace canceled stock options and would balance share
ownership among key officers for past and prospective service.

The terms of the formula award require that the award be contributed to the
Company's deferred compensation plan, and be used to purchase shares of the
Company in the open market. The formula award vests over a three-year period, on
the anniversary date of the Merger, beginning on December 31, 1998.

In the aggregate, the market capitalizations of the Predecessor Companies
increased by approximately $319 million from August 14, 1997 to December 30,
1997, and the total formula award was computed to be $19.0 million. The total
expense recorded as a result of the formula awards during 1998 was $6.2 million,
or approximately $0.12 per share. Assuming all officers who received a formula
award remain with the Company over the remaining vesting period, the Company
will expense the remaining formula award during 1999 and 2000 in an annual
amount of approximately $6.4 million.

Net realized gains were $22.5 million, $10.7 million and $19.2 million for
the years ended December 31, 1998, 1997 and 1996, respectively. These gains
resulted from the sale of equity securities associated with certain mezzanine
and commercial mortgage loans and the realization of unamortized discount
resulting from the early repayment of mezzanine and commercial mortgage loans,
offset by losses on investments.

Realized gains totaled $25.8 million, $15.8 million and $30.4 million for
the years ended December 31, 1998, 1997 and 1996, respectively. Realized gains
during 1998 primarily resulted from transactions involving ten portfolio
companies: ARS ($1.1 million), Calendar Broadcasting ($1.1 million), Arlington
Square Associates ($1.9 million), DMI Furniture ($0.6 million), Virginia Beach
Associates ($2.4 million), Labor Ready, Inc. ($5.0 million), Broadcast Holdings,
Inc. ($1.1 million), Waterview Limited Partnership ($3.0 million), Z-Spanish
Radio Network, Inc. ($2.7 million) and El Dorado Communications, Inc. ($0.8
million). Gains resulting from investments in these ten companies totaled $19.7
million. The Company also realized a gain of $4.0 million from the sale of an
office building owned by Allied Capital Advisers Inc. prior to the Merger and
incurred an income tax liability related to that gain of $0.8 million. Realized
gains in 1997 resulted from transactions involving 83 portfolio companies.

Realized losses in 1998, 1997 and 1996 totaled $3.3 million, $5.1 million
and $11.2 million and represented 0.4%, 0.6% and 1.6% of the Company's total
assets, respectively. Realized losses in 1998 resulted primarily from the full
or partial liquidation

23
<PAGE> 28

of three portfolio investments: SunStates Refrigerated Services, Inc. ($1.8
million), R-Tex Decoratives Company, Inc. ($0.6 million), and Pines Hotel ($0.3
million). These three investments resulted in realized losses of $2.7 million.
Realized losses in 1997 resulted primarily from the full or partial liquidation
of four investments: Taco Tico, Inc. ($1.1 million), SunStates Refrigerated
Services, Inc. ($0.8 million), Enviroplan, Inc. ($0.8 million), and Vineyard
Sycamore Plaza Associates ($0.4 million). Realized losses resulting from these
four investments totaled $3.1 million. Realized losses in 1996 included $6.6
million in losses from the liquidation of two portfolio investments. The Company
made loans to these two borrowers in the late 1980s and early 1990s, and each
borrower encountered significant difficulties during the recession of the early
1990's. Losses realized in 1998, 1997 and 1996 had been recognized in NIA over
time as unrealized depreciation when the Company determined that the respective
portfolio security's value had become impaired. Thus, the Company reversed
previously recorded unrealized depreciation totaling $3.6 million, $9.7 million
and $7.5 million when the related losses were realized in 1998, 1997 and 1996,
respectively.

The Company recorded net unrealized gains of $1.1 million and $7.2 million
for the years ended December 31, 1998 and 1997, respectively, and net unrealized
losses of $7.4 million for the year ended December 31, 1996. Net unrealized
gains for 1998 consisted of valuation changes resulting from the Board of
Directors' valuation of the Company's assets, the effect of valuation of
interest rate swap agreements, and the effect of reversals of net unrealized
appreciation resulting from net realized gains. At December 31, 1998, net
unrealized appreciation in the portfolio totaled $2.4 million, and was composed
of unrealized appreciation of $27.3 million resulting primarily from appreciated
equity interests in portfolio companies, and unrealized depreciation of $24.9
million resulting primarily from underperforming loan and equity investments in
the portfolio. At December 31, 1997, net unrealized appreciation in the
portfolio totaled $1.3 million and was composed of unrealized appreciation of
$19.2 million and unrealized depreciation of $17.9 million. At December 31,
1996, net unrealized depreciation in the portfolio totaled $5.9 million.

The Company employs a standard grading system for the entire portfolio.
Grade 1 is used for those loans from which a capital gain is expected. Grade 2
is used for loans performing in accordance with plan. Grade 3 is used for loans
that require closer monitoring; however, no loss of interest or principal is
expected. Grade 4 is used for loans for which some loss of contractually due
interest is expected, but no loss of principal is expected. Grade 5 is used for
loans for which some loss of principal and interest is expected and the loan is
written down to net realizable value. During 1998, the Company began to grade
its commercial mortgage and 7(a) loan portfolios using the same grading system
used for its mezzanine loan portfolio, so that the Company's entire portfolio
would

24
<PAGE> 29

have a uniform grading system. Prior to this, the commercial real estate
portfolio used a different grading system and the 7(a) loan portfolio was not
graded.

At December 31, 1998, the Company's portfolio was graded as follows:

<TABLE>
<CAPTION>
PORTFOLIO BY GRADE
------------------ INVESTMENTS PERCENTAGE OF
AT VALUE TOTAL PORTFOLIO
------------- ---------------
(IN MILLIONS)
<S> <C> <C>
1............................................ $104.4 13.0%
2............................................ 618.0 77.2
3............................................ 53.2 6.7
4............................................ 11.8 1.5
5............................................ 12.9 1.6
------ -----
$800.3 100.0%
====== =====
</TABLE>

Grade 5 mezzanine investments totaled $6.4 million at value at December 31,
1998, or 0.8% of the Company's total portfolio based on the valuation of the
Board of Directors. The value of these Grade 5 investments has been reduced from
an aggregate cost of $22.7 million in order to reflect the Company's estimate of
the net realizable value of these investments upon disposition. This reduction
in value has been recorded previously as unrealized depreciation over several
years in the Company's earnings. The Company continues to follow its historical
practices of working with a troubled portfolio company in order to recover the
maximum amount of the Company's investment, but records unrealized depreciation
for a substantial amount of the potential exposure when such exposure is
identified. During 1998, Grade 5 mezzanine investments decreased by $6.5 million
from $12.9 million at December 31, 1997.

At December 31, 1998, commercial real estate Grade 5 loans totaled $0.1
million at value. The value of these Grade 5 loans approximates cost because of
the estimated value of the underlying collateral securing the loans. A Grade 5
classification for a commercial real estate loan prior to the use of the uniform
grading system meant that the loan was in workout. Because of the collateral
securing these loans, however, few previous Grade 5 loans were ever expected to
result in loss of principal. Of the loans included in Grade 5 at December 31,
1997, only one loan totaling $0.3 million at cost was expected to incur any loss
of principal, and this loan was valued at $0.2 million.

Grade 5 SBA 7(a) loans totaled $6.3 million at value at December 31, 1998,
and have been reduced from an aggregate cost basis of $7.9 million. The SBA 7(a)
loan portfolio was not graded at December 31, 1997.

For the total portfolio, loans greater than 120 days delinquent were $13.7
million at value at December 31, 1998, or 1.7% of the total portfolio. Included
in this category are loans valued at $9.9 million that are fully secured by real
estate. Loans greater than 120 days delinquent generally do not accrue interest.
Loans greater than 120 days delinquent at December 31, 1997, were $20.2 million
at value or 2.9% of the total portfolio.

The Company incurred income tax expense of $0.8 million for the year ended
December 31, 1998, which resulted from the taxation of a net built-in gain
realized from the sale of an office building owned by Allied Capital Advisers
Inc. prior to the Merger. The Company incurred income tax expense of $1.4
million and $1.9 million, respectively, for the years ended December 31, 1997
and 1996 resulting from the operations of Allied Capital Advisers Inc. Because
the Company has elected to be taxed as a regulated

25
<PAGE> 30

investment company ("RIC") under Subchapter M of the Code, the Company is not
taxed on its investment company taxable income and realized capital gains, to
the extent that such income and gains are distributed to shareholders.

During 1998, 1997 and 1996, the Company or the Predecessor Companies
declared dividends to their shareholders representing all of each company's
ordinary taxable income, taxable net capital gains, and, in the case of Allied
Capital Corporation in 1997, a partial return of capital resulting from the
distribution of Allied Capital Corporation's ownership of Allied Capital Lending
Corporation's shares. Tax distributions differ from NIA due to timing
differences in the recognition of income and expenses, returns of capital and
net unrealized appreciation, which is not included in taxable income. Total tax
distributions declared were $75.1 million, $85.7 million and $57.4 million for
1998, 1997 and 1996, respectively. Tax distributions per share were $1.43, $1.71
and $1.23 for the three years ended December 31, 1998, 1997 and 1996,
respectively. The per share distributions for 1997 and 1996 have been exchange
adjusted for the Merger and include the exchange-adjusted shares of Allied
Capital Advisers Inc. for which no tax distributions had historically been
declared or paid.

Included in 1997 tax distributions was $18 million, or $0.34 per share,
representing a non-cash dividend of the shares of Allied Capital Lending
Corporation held in Allied Capital Corporation's portfolio. Allied Capital
Corporation declared and paid a dividend equal to 0.107448 shares of Allied
Capital Lending Corporation for each share of Allied Capital Corporation held on
the record date for such dividend. These shares had a market value of $21.25 per
share on December 30, 1997, the distribution date.

Also included in 1997 tax distributions was a special, one-time dividend
equal to $8.8 million, or $0.17 per share, representing all of the retained
earnings and profits of the Predecessor Companies at December 31, 1997. The
special dividend was declared in conjunction with the Merger in order for the
Company to maintain its RIC status.

Certain of the Company's credit facilities limit the Company's ability to
declare dividends if the Company has defaulted under certain provisions of the
credit agreement.

The weighted average common shares outstanding used to compute basic
earnings per share were 51.9 million, 49.2 million and 46.2 million for the
years ended December 31, 1998, 1997 and 1996, respectively. The increases in the
weighted average shares reflect the issuance of new shares, the exercise of
employee stock options to purchase shares of the Company and the issuance of
shares pursuant to a dividend reinvestment plan. Allied Capital Corporation's
ownership of Allied Capital Lending Corporation during the periods presented has
been eliminated in consolidation.

All per share amounts included in management's discussion and analysis have
been computed using the weighted average shares used to compute diluted earnings
per share, which were 52.0 million, 49.3 million and 46.7 million for the years
ended December 31, 1998, 1997 and 1996, respectively.

26
<PAGE> 31

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

CASH AND CASH EQUIVALENTS

At March 31, 1999, the Company had $35.2 million in cash and cash
equivalents. The Company invests otherwise uninvested cash in U.S. government or
agency-issued or guaranteed securities that are backed by the full faith and
credit of the United States, or in high quality, short-term repurchase
agreements fully collateralized by such securities. The Company's objective is
to manage to a low cash balance and fund new originations with its lines of
credit.

INDEBTEDNESS

The Company had outstanding indebtedness at March 31, 1999 as follows:

<TABLE>
<CAPTION>
ANNUAL
PORTFOLIO RETURN TO
AMOUNT ANNUAL COVER INTEREST
CLASS OUTSTANDING INTEREST RATE(1) PAYMENTS(2)
----- -------------- ---------------- -------------------
(IN THOUSANDS)
<S> <C> <C> <C>
Debentures and notes
payable:
Master loan and
security agreement... $ 56,392 5.94% 0.35%
Unsecured long-term
notes payable........ 180,000 7.21% 1.36%
SBA debentures......... 47,650 8.22% 0.41%
OPIC loan.............. 5,700 6.57% 0.04%
--------
Total debentures
and notes
payable......... $289,742 7.12% 2.15%
========
Revolving line of credit.... $121,000 7.35% 0.93%
========
</TABLE>

- ---------------

(1) The annual interest rate includes the cost of commitment fees and other
facility fees.

(2) The annual portfolio return to cover interest payments ("Annual Return") is
calculated as total estimated 1999 annual interest or dividend payments per
class of financing, divided by total assets at March 31, 1999. The total
Annual Return needed to cover all classes of financing at March 31, 1999
combined is 3.08%.

MASTER LOAN AND SECURITY AGREEMENT. The Company, in conjunction with
Business Mortgage Investors, Inc. ("BMI"), has a facility to borrow up to $250
million, of which $100 million is committed, using its commercial mortgage loans
as collateral. The agreement generally requires interest-only payments with all
principal due at maturity. The agreement bears interest at one-month London
Inter-Bank Offered Rate ("LIBOR") plus 1.0%. The facility matures on October 7,
1999.

UNSECURED LONG-TERM NOTES PAYABLE. The Company has $180 million in
financing through the issuance of unsecured long-term notes with private
institutional lenders, primarily insurance companies. The terms of the notes
include five- or seven-year maturities, priced at a weighted average rate of
7.2%. The notes require payment of interest only semiannually, and all principal
is due upon maturity.

On May 5, 1999, the Company closed $137 million in additional new long-term
financing through the issuance of unsecured long-term notes with private
institutional lenders, primarily insurance companies. The terms of the notes
include five- or seven-year maturities, priced at a weighted average rate of
7.4%, on substantially the same terms. The notes require payment of interest
only semiannually, and all principal is due upon maturity. Proceeds from the
notes will be used to pay down the Company's short-term borrowings.

27
<PAGE> 32

SBA DEBENTURES. The Company, through its SBIC subsidiary, has debentures
totaling $47.7 million payable to the SBA, at interest rates ranging from 6.9%
to 9.6% with scheduled maturity dates as follows: 1999 -- $0; 2000 -- $17.3
million; 2001 -- $9.4 million; 2002 -- $0; 2003 -- $0; and $21.0 million
thereafter. The debentures require semi-annual interest-only payments with all
principal due upon maturity. During 1997, Congress increased the maximum
leverage available to an SBIC to $101.0 million, and the Company intends to
continue to borrow under the SBIC program as the situation warrants. The Company
currently has a commitment from the SBA for an additional $27.0 million of debt.

REVOLVING LINE OF CREDIT. The Company has a two-year, $315 million
unsecured revolving line of credit which expires in March, 2001. This facility
will shortly be increased to $340 million and may be expanded up to $400
million. At the Company's option, the credit facility bears interest at a rate
equal to (i) LIBOR plus 1.25% or (ii) the higher of (a) the NationsBank, N.A.
prime rate and (b) the Federal Funds rate plus 0.50%. The credit facility
requires monthly payments of interest, and all principal is due upon maturity.
The credit facility also requires an annual facility fee equal to 0.25% of the
committed amount, regardless of the amount outstanding under the facility, which
is payable quarterly in arrears.

EQUITY CAPITAL AND DIVIDENDS

During the first quarter of 1999, the Company raised $35.8 million in new
equity primarily through the sale of shares from its shelf registration
statement. At March 31, 1999, total shareholders' equity had increased to $523.0
million.

The Company expects to distribute four regular quarterly dividends of $0.40
per share during 1999, for total dividends of at least $1.60 per share for 1999.
During the first quarter of 1999, the board of directors declared and the
Company paid a regular quarterly dividend of $0.40 per share.

The Company's dividend policy is to distribute substantially all of its
taxable income, including capital gains, annually. The Company's taxable income
can differ from its financial reporting income due to differences in the timing
of revenue and expense recognition. The Company's current regular dividend was
determined based on estimated 1999 taxable income. Dividends for 1998 totaled
$1.43 per share.

FUTURE DEBT OR EQUITY OFFERINGS

The Company plans to secure additional debt and equity capital for
continued investment in growing businesses. Because the Company is a RIC, it
distributes substantially all of its income and requires external capital for
growth. Because the Company is a business development company, it is limited in
the amount of debt capital it may use to fund its growth, since it is generally
required to maintain a ratio of 200% of total assets to total borrowings.

The Company plans to maintain a strategy of financing its operations,
dividend requirements and future investments with cash from operations, through
borrowing under short- or long-term credit facilities, through asset sales, or
through obtaining new equity capital. The Company will utilize its short-term
credit facilities only as a means to bridge to long-term financing. The Company
evaluates its interest rate exposure on an ongoing basis and may hedge variable
and short-term interest rate exposure through interest rate swaps, Treasury
locks and other techniques when appropriate. The Company believes that

28
<PAGE> 33

it has access to capital sufficient to fund its ongoing investment and operating
activities, and from which to pay dividends.

FINANCIAL OBJECTIVES

The Company has set forth certain financial objectives that it intends to
use in allocating its resources and in selecting new investment opportunities.
Management's goal is to increase NIA annually by 15% to 20% and to result in a
ratio of NIA to average shareholders' equity, or return on equity, of 19% to
22%. Management believes that the Company will be able to achieve these goals
over the next three to five years. Factors that may impede the achievement of
these objectives include those described under "Risk Factors" and also include
other factors such as changes in the economy, competitive and market conditions,
and future business decisions.

YEAR 2000 COMPLIANCE

The Company has a Year 2000 compliance committee which is responsible for
assessing the Company's Year 2000 readiness by focusing on three main areas: the
Company's information technology ("IT") and other operating systems, service
providers, and portfolio companies. The committee reports periodically to the
board of directors and to executive management.

The Company's IT systems consist of third-party software and relatively new
hardware systems. All vendors providing critical software and hardware have
indicated that their programs and systems are Year 2000 compliant. All testing
of critical software should be completed by May 31, 1999. The Company has tested
most of its critical software applications and the test results have indicated
the software and systems are Year 2000 compliant. In addition to the testing
performed by Company personnel, the Company also contracted with its loan
accounting software vendor to perform independent validation tests, using the
Company's data, to verify that this software will be Year 2000 compliant. The
test results revealed that the Company's loan accounting software is currently
Year 2000 compliant. Implementation of tested software and IT systems is planned
to be completed by the end of the second quarter 1999. The Company currently has
service and maintenance contracts with all its critical software vendors,
therefore, no additional costs will be incurred by the Company for the upgrades
needed to become compliant.

The second area of focus is the Company's service providers. The Company
continues to monitor all of its critical service providers as they work toward
Year 2000 compliance. The Company is not aware of any critical service provider
that will not be Year 2000 compliant. However, the Company cannot give any
assurance that the service providers will be Year 2000 compliant and that no
interruption of business will occur as a result of their noncompliance.

The Company has sent Year 2000 questionnaires to its portfolio companies to
assess their awareness and to evaluate their Year 2000 readiness. Based on the
responses to the Year 2000 questionnaires, the portfolio companies have
represented that they will be Year 2000 compliant by December 31, 1999. The
Company will continue to monitor the progress of its portfolio companies that
are working toward Year 2000 compliance. During 1998, the Company began to
evaluate each new portfolio company's Year 2000 compliance as part of the due
diligence process. No assurance can be given that certain of the Company's
portfolio companies will not suffer material adverse effects from Year 2000
issues, and if such adverse effects impact such companies' ability to repay
their loans, the Company's operating results and financial condition could be
affected.

29
<PAGE> 34

The Company estimates its operating costs to reach Year 2000 compliance
will be approximately $100,000, and these costs are included in the Company's
1999 budget. This includes time allocated to this task by Company personnel and
costs incurred in the testing phase.

While the Company believes that it is taking the necessary steps to be Year
2000 compliant, it is difficult to fully predict the impact on the Company of
non-compliance in any of the above-mentioned areas. Significant non-compliance
could result in a material adverse effect on the Company's financial conditions
and results from operations. The Company believes that the worst case Year 2000
scenarios may include 1) incurring additional costs to maintain the Company's
books and records and to service the Company's investment portfolio, 2) the
inability of the Company to access or transfer cash needed to pay its bills or
fund new investments, 3) an increase in delinquencies and/or losses due to Year
2000 problems with the Company's portfolio companies, or 4) disruption in the
capital markets resulting in a lack of liquidity to the Company. The degree of
impact resulting from any of these worst case scenarios cannot be determined at
this time. The Company is currently assessing its contingency plan, taking into
consideration these worst-case scenarios. This plan will be finalized after the
Year 2000 compliance tests and surveys described above are completed.

30
<PAGE> 35

SENIOR SECURITIES

Information about our senior securities is shown in the following tables as
of the fiscal year ended December 31, unless otherwise noted. The "-- "
indicates information which the Commission expressly does not require to be
disclosed for certain types of senior securities.

UNSECURED LONG-TERM NOTES
PAYABLE
1989........................ $ 0 $ 0 $-- N/A
1990........................ 0 0 -- N/A
1991........................ 0 0 -- N/A
1992........................ 0 0 -- N/A
1993........................ 0 0 -- N/A
1994........................ 0 0 -- N/A
1995........................ 0 0 -- N/A
1996........................ 0 0 -- N/A
1997........................ 0 0 -- N/A
1998........................ 180,000,000 2,734 -- N/A
1999 (as of March 31)....... 180,000,000 2,460 -- N/A

SBA DEBENTURES(5)
1989........................ $ 25,350,000 $4,015 $-- N/A
1990........................ 40,450,000 3,397 -- N/A
1991........................ 49,800,000 3,834 -- N/A
1992........................ 49,800,000 5,789 -- N/A
1993........................ 49,800,000 6,013 -- N/A
1994........................ 54,800,000 3,695 -- N/A
1995........................ 61,300,000 2,868 -- N/A
1996........................ 61,300,000 2,485 -- N/A
1997........................ 54,300,000 2,215 -- N/A
1998........................ 47,650,000 2,734 -- N/A
1999 (as of March 31)....... 47,650,000 2,460 -- N/A
</TABLE>

31
<PAGE> 36

<TABLE>
<CAPTION>
TOTAL AMOUNT
OUTSTANDING INVOLUNTARY
EXCLUSIVE OF ASSET LIQUIDATING AVERAGE
TREASURY COVERAGE PREFERENCE MARKET VALUE
CLASS AND YEAR SECURITIES(1) PER UNIT(2) PER UNIT(3) PER UNIT(4)
-------------- ------------- ----------- ----------- --------------
<S> <C> <C> <C> <C>
OVERSEAS PRIVATE INVESTMENT
CORPORATION LOAN
1989........................ $ 0 $ 0 $-- N/A
1990........................ 0 0 -- N/A
1991........................ 0 0 -- N/A
1992........................ 0 0 -- N/A
1993........................ 0 0 -- N/A
1994........................ 0 0 -- N/A
1995........................ 0 0 -- N/A
1996........................ 8,700,000 2,485 -- N/A
1997........................ 8,700,000 2,215 -- N/A
1998........................ 5,700,000 2,734 -- N/A
1999 (as of March 31)....... 5,700,000 2,460 -- N/A
REVOLVING LINES OF CREDIT
1989........................ $ 0 $ 0 $-- N/A
1990........................ 0 0 -- N/A
1991........................ 0 0 -- N/A
1992........................ 0 0 -- N/A
1993........................ 0 0 -- N/A
1994........................ 32,226,000 3,695 -- N/A
1995........................ 20,414,000 2,868 -- N/A
1996........................ 45,099,000 2,485 -- N/A
1997........................ 38,842,000 2,215 -- N/A
1998........................ 95,000,000 2,734 -- N/A
1999 (as of March 31)....... 121,000,000 2,460 -- N/A
SENIOR NOTE PAYABLE(6)
1989........................ $ 0 $ 0 $-- N/A
1990........................ 0 0 -- N/A
1991........................ 0 0 -- N/A
1992........................ 20,000,000 5,789 -- N/A
1993........................ 20,000,000 6,013 -- N/A
1994........................ 20,000,000 3,695 -- N/A
1995........................ 20,000,000 2,868 -- N/A
1996........................ 20,000,000 2,485 -- N/A
1997........................ 20,000,000 2,215 -- N/A
1998........................ 0 0 -- N/A
1999 (as of March 31)....... 0 0 -- N/A
BONDS PAYABLE
1989........................ $ 0 $ 0 $-- N/A
1990........................ 0 0 -- N/A
1991........................ 0 0 -- N/A
1992........................ 0 0 -- N/A
1993........................ 0 0 -- N/A
1994........................ 0 0 -- N/A
1995........................ 98,625,000 2,868 -- N/A
1996........................ 54,123,000 2,485 -- N/A
1997........................ 0 0 -- N/A
1998........................ 0 0 -- N/A
1999 (as of March 31)....... 0 0 -- N/A
</TABLE>

32
<PAGE> 37

<TABLE>
<CAPTION>
TOTAL AMOUNT
OUTSTANDING INVOLUNTARY
EXCLUSIVE OF ASSET LIQUIDATING AVERAGE
TREASURY COVERAGE PREFERENCE MARKET VALUE
CLASS AND YEAR SECURITIES(1) PER UNIT(2) PER UNIT(3) PER UNIT(4)
-------------- ------------- ----------- ----------- --------------
<S> <C> <C> <C> <C>
REVERSE REPURCHASE AGREEMENTS(7)
1989........................ $ 29,386,000 $4,015 $ -- N/A
1990........................ 28,361,000 3,397 -- N/A
1991........................ 2,761,000 3,834 -- N/A
1992........................ 0 0 -- N/A
1993........................ 0 0 -- N/A
1994........................ 0 0 -- N/A
1995........................ 0 0 -- N/A
1996........................ 0 0 -- N/A
1997........................ 0 0 -- N/A
1998........................ 0 0 -- N/A
1999 (as of March 31)....... 0 0 -- N/A
REDEEMABLE CUMULATIVE PREFERRED STOCK(5)
1989........................ $ 0 $ 0 $ 0 N/A
1990........................ 1,000,000 308 100 N/A
1991........................ 1,000,000 338 100 N/A
1992........................ 1,000,000 526 100 N/A
1993........................ 1,000,000 546 100 N/A
1994........................ 1,000,000 351 100 N/A
1995........................ 1,000,000 277 100 N/A
1996........................ 1,000,000 242 100 N/A
1997........................ 1,000,000 217 100 N/A
1998........................ 1,000,000 267 100 N/A
1999 (as of March 31)....... 1,000,000 239 100 N/A
NON-REDEEMABLE CUMULATIVE PREFERRED
STOCK(5)
1989........................ $ 6,000,000 $ 362 $ 100 N/A
1990........................ 6,000,000 308 100 N/A
1991........................ 6,000,000 338 100 N/A
1992........................ 6,000,000 526 100 N/A
1993........................ 6,000,000 546 100 N/A
1994........................ 6,000,000 351 100 N/A
1995........................ 6,000,000 277 100 N/A
1996........................ 6,000,000 242 100 N/A
1997........................ 6,000,000 217 100 N/A
1998........................ 6,000,000 267 100 N/A
1999 (as of March 31)....... 6,000,000 239 100 N/A
</TABLE>

- -------------------------
(1) Total amount of each class of senior securities outstanding at the end
of the period presented.

(2) The asset coverage ratio for a class of senior securities representing
indebtedness is calculated as the Company's consolidated total assets,
less all liabilities and indebtedness not represented by senior
securities, divided by senior securities representing indebtedness. This
asset coverage ratio is multiplied by $1,000 to determine the Asset
Coverage Per Unit. The asset coverage ratio for a class of senior
securities that is preferred stock is calculated as the Company's
consolidated total assets, less all liabilities and indebtedness not
represented by senior securities, divided by senior securities
representing indebtedness, plus the involuntary liquidation preference
of the preferred stock (see footnote 3). The Asset Coverage Per Unit for
preferred stock is expressed in terms of dollar amounts per share.

(3) The amount to which such class of senior security would be entitled upon
the involuntary liquidation of the issuer in preference to any security
junior to it.

33
<PAGE> 38

(4) Not applicable, as senior securities are not registered for public
trading.

(5) Issued by the Company's SBIC subsidiary to the SBA. These categories of
senior securities are not subject to the asset coverage requirements of
the 1940 Act. See "Certain Government Regulations -- SBA Regulations."

(6) The Company was the obligor on $15 million of the senior notes. The
Company's SBIC subsidiaries were the obligors on the remaining $5
million, which is not subject to the asset coverage requirements of the
1940 Act.

(7) U.S. government agency guaranteed loans sold under agreements to
repurchase. The Company was advised by the Staff of the Commission that
these reverse repurchase agreements were not considered a class of
senior security representing indebtedness and thus were not subject to
the asset coverage requirements of the 1940 Act.

34
<PAGE> 39

BUSINESS

We are a value-added full-service lender. We invest in and lend to private,
growing businesses in a variety of industries and in diverse geographic
locations nationwide. We focus on investments in three primary areas:

- mezzanine finance

- commercial real estate finance, including the purchase of CMBS, and

- SBA 7(a) lending.

Our investment portfolio consists primarily of small and medium-sized
subordinated loans with equity features, small and medium-sized commercial
mortgage loans, commercial mortgage-backed securities, and small senior loans.
At March 31, 1999, our investment portfolio totaled $886 million representing
678 borrower relationships in 40 states and the District of Columbia.

The Company's investment objective is to achieve current income and capital
gains. We currently do not have a policy with respect to "concentrating" (i.e.,
investing 25% or more of our total assets) in any industry or group of
industries and currently our portfolio is not concentrated. We may or may not
concentrate in any industry or group of industries in the future.

THE 1997 MERGER

Allied Capital Corporation was formed through the merger, on December 31,
1997, of five affiliated public companies, the "predecessor companies", the
oldest of which was founded in 1958. The merger provided numerous benefits and
key competitive advantages:

- INCREASED SIZE. We are now the largest BDC in the United States and are
significantly larger than any of the predecessor companies that merged in
terms of total assets, total equity capital and total market
capitalization. A larger asset base allows us to make larger investments
in growing companies while maintaining portfolio diversity. A larger
market capitalization provides our stockholders with better liquidity,
and has increased our visibility in the debt and equity capital markets.
These improvements have provided the Company with a better foundation for
growth.

- IMPROVED MIX OF INCOME. We now have a portfolio that produces a higher
level of recurring investment income since the five companies merged. In
addition, as a single company, we have been able to expand our existing
businesses and improve our asset and liability management.

- EFFICIENCY. As one company, we now operate more efficiently. We have
been able to eliminate redundant processes and expenses, including
financial reporting, auditing, and corporate legal fees.

- SINGLE ENTITY FOCUSED ON HIGH RETURN INVESTMENTS. We now have one
business plan with a single investment goal of generating strong current
income and long-term capital gains. We are able to allocate both capital
and human resources more effectively to maximize our returns on
shareholder equity.

- INCREASED COMPETITIVENESS. Because of our increased size, focus, and
efficiency, we have become a formidable competitor in the mezzanine
finance marketplace. Our increased size has lowered our cost of capital
and increased our pricing competitiveness. Our increased size has also
enabled us to finance larger

35
<PAGE> 40

transactions while maintaining portfolio diversity. Our increased
efficiency has enabled us to grow both our sales and investment
professional headcount so that we can more aggressively compete in the
marketplace.

As a result of the merger, we increased our annual loan originations and
improved the credit quality of our portfolio. We also increased our access to
capital, particularly our ability to borrow from lenders. During 1998, we
restructured our credit facilities and obtained unsecured debt financing at a
lower cost with more favorable financing terms. In addition, we believe our
larger market capitalization has increased our access to equity capital. Greater
access to capital at a lower cost has enabled us to price our loans to borrowers
more competitively.

MEZZANINE FINANCE

We provide mezzanine debt and equity financing in private transactions for
small- and medium-sized growth companies. We recognize that entrepreneurs need
an alternative to the high cost and dilutive nature of venture equity capital.
Therefore, our mezzanine finance activities target a market niche between the
senior debt financing provided by traditional lenders, such as banks and
insurance companies, and the equity capital provided by venture capitalists and
private equity investors.

Our mezzanine financing is generally used to fund growth, leveraged
buyouts, note purchases, loan restructurings, acquisitions, recapitalizations,
and bridge financings. We generally invest in private companies though, from
time to time, we may invest in thinly traded public companies that lack access
to public capital and whose securities are generally not marginable.

We originate and purchase investments ranging in size from $5 million to
$25 million, with an emphasis on investments on the higher end of this range.
Our mezzanine investments are generally structured as a subordinated loan that
carries a relatively high fixed interest rate (12% to 18%), with interest-only
payments in the early years and payments of both principal and interest in the
later years, with maturities of five to ten years. Our mezzanine investments may
also include equity features, such as warrants or options to buy a minority
interest in the portfolio company. At March 31, 1999, approximately 98% of the
Company's mezzanine investments had fixed interest rates.

We seek to generate a return on assets ranging from 14% to 20%, including
both interest income and capital gains from the sale of our equity interests.
Historically, we had structured our mezzanine investments so that approximately
one-half of the potential return was earned through current interest payments,
and one-half was earned in capital gains, which would arise from the sale of our
equity interest in the portfolio company. We generally structure our mezzanine
investments with more emphasis on current interest, and less emphasis on the
potential return from capital gains. At March 31, 1999, our mezzanine portfolio
had a weighted average yield of 14.0%, as compared to a weighted average yield
of 13.2% at March 31, 1998.

Our equity investments, which include warrants, options, and common and
preferred stock, generally do not produce a current return, but are held for
potential investment appreciation and ultimate capital gains. Generally,
warrants are exercisable after a three- to five-year period, and the exercise
price is usually nominal. The warrants often include registration rights, which
allow us to sell the securities if the portfolio company completes a public
offering. In many cases, the warrants have a put option that requires that the

36
<PAGE> 41

borrower repurchase our equity position after a specified period of time at a
formula price or at its fair market value.

At March 31, 1999, our mezzanine portfolio had $351.6 million in mezzanine
loans and debt securities, and $55.9 million in equity interests, which combined
represented 42% of our total assets. The geographic and industry composition of
the mezzanine portfolio at March 31, 1999 was as follows:

<TABLE>
<CAPTION>
GEOGRAPHIC REGION
-----------------
<S> <C>
Mid-Atlantic.................. 26%
Midwest....................... 25%
Southeast..................... 22%
West.......................... 15%
International................. 7%
Northeast..................... 5%
----
Total.................... 100%
====
INDUSTRY
--------
Consumer products............. 22%
Telecommunications............ 15%
Business services............. 13%
Retail........................ 8%
Industrial products........... 8%
Broadcasting.................. 6%
Other......................... 28%
----
Total.................... 100%
====
</TABLE>

Private equity and mezzanine investment partnerships are our primary
competitors in the mezzanine finance business. We believe that we have certain
structural and operational advantages when compared to many of these
competitors. Our scale of operations, equity capital base, and successful track
record as a mezzanine lender has enabled us to borrow long-term capital to
leverage our equity and reduce our overall cost of capital. We use our lower
cost of capital to price our loans competitively. In addition, the perpetual
nature of our corporate structure enables us to be a better long-term partner
for our borrowers than traditional mezzanine partnerships, which typically have
a limited life. We also believe that high overhead, cumbersome regulatory
structures and large size hinder many traditional lenders from lending
effectively to our niche of small- and medium-sized businesses.

We hold a portion of our mezzanine investments in a wholly owned
subsidiary, Allied Investment Corporation. Allied Investment is a BDC and is
licensed and regulated by the Small Business Administration to operate as a
small business investment company ("SBIC"). See "Certain Government Regulations"
below for further information about SBIC regulation.

COMMERCIAL REAL ESTATE FINANCE

COMMERCIAL MORTGAGE LOANS. We originate and purchase mortgage loans to
small and medium-sized businesses secured by commercial real estate. We believe
that we successfully compete in the commercial real estate finance market due to
our creativity and flexible loan terms. We use an "enterprise value" approach to
assess new commercial mortgage loans, which requires an analysis of the
underlying cash flow of the real estate tenant or owner-occupant in addition to
more traditional real estate loan underwriting techniques, which may exclude the
impact of business cash flows from the underwriting considerations. We believe
that we are able to structure and finance more complicated loans than
traditional real estate lenders due to our significant expertise in this area,
and the experience of our investment professionals.

We generally price new commercial mortgage loans based on a fixed spread
ranging from 3% to 5% over five to ten year U.S. Treasury rates. During 1997 and
1998, interest rates on U.S. Treasury bonds declined significantly, and the
spreads charged by commercial real estate lenders in the marketplace narrowed.
As a result, we began to

37
<PAGE> 42

reevaluate our strategy regarding commercial real estate lending in light of
declining interest rates. During the third quarter of 1998, we significantly
reduced our commercial mortgage loan origination activity for our own portfolio,
and began exploring opportunities to originate commercial mortgage loans for
sale to various financial institutions.

We are now pursuing various loan sale opportunities and we plan to continue
to originate commercial mortgage loans for sale. We can enhance the investment
return from our commercial mortgage loan portfolio by originating and selling
these lower-yielding loans, because we receive loan origination fees and cash
premiums on the sale from the purchaser. We are combining our commercial
mortgage loan origination for sale activity with our SBA lending activity in
order to increase our competitiveness in the marketplace. In addition, small
commercial mortgage loans generally are priced such that the premiums realized
upon sale are greater than those realized on larger, more competitively priced,
commercial mortgage loans.

We focus on originating commercial mortgage loans for our own portfolio
ranging in size from $1 million to $25 million with maturities of five to ten
years. These loans are generally priced at higher interest rates and include
subordinated real estate loans and sale-leaseback financing. Subordinated loans
are priced similarly to our mezzanine loans and may be accompanied by an equity
interest in the real estate or in the underlying business.

At March 31, 1999, 60% of the Company's portfolio of commercial mortgage
loans carried a fixed interest rate, and 40% carried a floating rate tied to
various indices. These loans may require payments of interest only, or they may
require level payments of principal and interest calculated to amortize the
principal on a 10- to 30-year basis with a balloon payment at maturity.

We derive income from the (1) interest charged on the commercial mortgage
loan portfolio and (2) amortization of original issue and purchased discounts.
The weighted average stated interest rate on the commercial mortgage loan
portfolio at March 31, 1999 was 9.8% and the weighted average yield was 10.4%.
The effective yield on the mortgage loan portfolio is higher than the stated
interest rate due to the amortization of original issue discount and purchased
discount. At March 31, 1999, the average loan-to-value for the commercial
mortgage loan portfolio was 66.5%.

The Company's commercial mortgage loan portfolio totaled approximately
$210.9 million at March 31, 1999, or 22% of the Company's total assets. The
geographic composition and the property types securing the commercial mortgage
loan portfolio at March 31, 1999 were as follows:

<TABLE>
<CAPTION>
GEOGRAPHIC REGION
-----------------
<S> <C>
Mid-Atlantic.................. 37%
Southeast..................... 29%
West.......................... 20%
Midwest....................... 9%
Northeast..................... 5%
----
Total.................... 100%
====
PROPERTY TYPE
-------------
Hospitality................... 46%
Office........................ 21%
Retail........................ 14%
Recreation.................... 12%
Other......................... 7%
----
Total.................... 100%
====
</TABLE>

We compete with banks, real estate conduits, equity and mortgage real
estate investment trusts ("REITs") and other lenders for the commercial mortgage
loans we originate. We believe we have earned a reputation in the commercial
real estate finance

38
<PAGE> 43

market as a specialist in credits that require more difficult structuring or
underwriting techniques, and that we compete successfully in this niche.

COMMERCIAL MORTGAGE-BACKED SECURITIES. Turmoil in the real estate capital
markets during the fourth quarter of 1998 created a unique opportunity for the
Company to acquire non-investment grade commercial mortgage-backed securities
("CMBS") at attractive yields. In late 1998, the Company purchased $67.2 million
of non-investment grade bonds for $32.2 million. During the first quarter of
1999, the Company purchased an additional $177.9 million of similar bonds for
$88.0 million. We plan to continue to purchase CMBS as long as we can achieve
significant discounts and attractive yields on such purchases. However, we may
limit our CMBS purchasing activity in order to maintain a balanced portfolio.

At March 31, 1999, the Company had $116.3 million in purchased commercial
mortgage-backed securities, which represented 12.1% of the Company's total
assets. The purchased CMBS portfolio had a weighted average yield to maturity of
14.6%.

In January 1998, we completed a $295 million asset securitization in which
we retained a residual interest in securitized loans. We continue to service all
of the loans in the pool. This transaction provided liquidity to our investment
portfolio, and allowed us to reinvest the cash proceeds from the securitization
into higher yielding mezzanine and SBA 7(a) loans. We do not anticipate
significant future securitization activity; we will gain liquidity from our
lower yielding loans primarily through whole loan sales. At March 31, 1999, the
Company had $84.5 million in Residual CMBS, which represented 8.8% of the
Company's total assets. The Residual CMBS had a weighted average yield to
maturity of 10.1%.

The CMBS in which we invest are non-investment grade, which means that
nationally recognized statistical rating organizations rate them below the top
four investment-grade rating categories (e.g., "AAA" through "BBB").
Non-investment grade securities usually pay a higher interest rate than do
investment-grade bonds, but with the higher return comes greater risk.
Non-investment grade securities are considered speculative, and their capacity
to pay principal and interest in accordance with the terms of their issue is not
ensured. They tend to react more to changes in interest rates than do
higher-rated securities, have a higher risk of default, tend to be less liquid,
and may be more difficult to value. We invest in non-investment grade CMBS
represented by the "BB" to non-rated tranches of a CMBS issuance. Due to the
underlying structure of the CMBS issuances that offer the non-investment grade
securities, our CMBS tranches receive principal payments only after the
securities that are senior to our securities are repaid. Thus, if losses are
incurred in the underlying mortgage loan collateral pool, we would experience
these losses. To mitigate this risk, we perform extensive due diligence prior to
the purchase of the non-rated CMBS.

When we evaluate a CMBS purchase, we use the same stringent underwriting
procedures and criteria for the pooled loans as we do for the loans we originate
and purchase. These underwriting procedures and criteria are described in detail
below. In addition, we believe that the underlying real estate collateral for
our purchased CMBS adequately secures our position. At March 31, 1999, the
average loan-to-value ratio for our commercial mortgage-backed securities
portfolio, including the residual interest in our securitized pool, was 68.7%.

39
<PAGE> 44

SBA 7(a) LENDING

We participate in the SBA's 7(a) Guaranteed Loan Program through a wholly
owned subsidiary, Allied Capital SBLC Corporation. Allied SBLC is licensed by
the SBA as a Small Business Lending Company ("SBLC"). It is one of only fourteen
non-bank SBLCs operating in the United States.

Under the SBA 7(a) program, we extend senior secured loans that are
partially guaranteed by the SBA. Our SBA 7(a) loans are provided to small
businesses for the purposes of acquiring real estate, purchasing machinery or
equipment, or providing working capital. The loans are secured by a mortgage or
other liens on the assets of the borrower, and in all cases the owners of the
business must personally guarantee the repayment of the loan. We focus our SBA
7(a) loan origination activity on loans secured by commercial real estate
assets.

Our 7(a) loans typically range in size from $250,000 to $1 million. The SBA
guarantees 80% of any qualified loan up to $100,000 regardless of maturity, and
75% of any qualified loan over $100,000 regardless of maturity, to a maximum
guarantee of $750,000 for any one borrower. SBA regulations define qualified
small businesses generally as businesses with (1) no more than $5 million in
annual sales or (2) no more than 500 employees. The SBA stipulates that loans
used to acquire real estate may have a maximum maturity of 25 years; loans used
to purchase machinery and equipment may have a maximum maturity of 15 years;
loans used for working capital may have a maximum maturity of seven years.

We generally price our 7(a) loans with variable interest rates typically
ranging from 1.75% to 2.75% over the prime rate, adjusted monthly. Approximately
96% of the Company's SBA 7(a) loan portfolio had variable interest rates as of
December 31, 1998. Generally loans are payable in equal monthly installments of
principal and interest on the first day of the month following the month in
which the loan is funded, until maturity. Our post-Merger capital structure has
allowed us to lower our pricing on SBA 7(a) loans. As a result, we believe we
now compete more effectively in the marketplace, and we have increased our deal
flow.

We routinely sell the guaranteed portion of our SBA 7(a) loans in the well-
established secondary market. We earn a premium on the sale of the guaranteed
portion of our SBA 7(a) loans. Typically our premiums on loan sales, net of
origination costs, range from 4% to 7.5% of the face amount of each loan sold.
This premium income enhances the return on our 25% retained investment in the
loan, and our retained portion is not subordinate to the guaranteed portion
sold. We continue to service 100% of each loan we originate.

For the fiscal year ended September 30, 1998, the federal government
estimated that SBA 7(a) loans originations would approximate $10.5 billion.
Banks, non-bank SBLCs, and certain state-sponsored non-bank lenders serve this
large market. We believe that we compete successfully in the 7(a) loan market
because we focus in certain regional markets and because we are a "Preferred
Lender" in the regional markets in which we compete. As an SBA Preferred Lender,
we are permitted to make 7(a) guaranteed loans without prior SBA credit
approval, thus simplifying and expediting our loan approval process and the
related disbursements. At March 31, 1999, Allied SBLC was a designated Preferred
Lender in sixteen markets; we plan to attain Preferred Lender status in
additional markets during 1999.

40
<PAGE> 45

Our SBA 7(a) loan portfolio totaled $58.3 million at March 31, 1999, or 6%
of our total assets. The SBA 7(a) portfolio includes loans to, among others,
hotels and motels, automotive shops and gas stations, restaurants,
manufacturers, broadcasting and communications companies, service providers,
retail shops, and other small businesses. The following tables show our 7(a)
loan portfolio by geographic region and industry at March 31, 1999:

<TABLE>
<CAPTION>
GEOGRAPHIC REGION
-----------------
<S> <C>
Midwest....................... 38%
Mid-Atlantic.................. 30%
Southeast..................... 15%
West.......................... 12%
Northeast..................... 5%
----
Total.................... 100%
====
</TABLE>

<TABLE>
<CAPTION>
INDUSTRY
--------
<S> <C>
Retail........................ 42%
Hospitality................... 29%
Consumer products............. 6%
Consumer services............. 5%
Business services............. 4%
Broadcasting.................. 3%
Other......................... 11%
----
Total.................... 100%
====
</TABLE>

INVESTMENT ADVISORY SERVICES

We are a registered investment adviser, pursuant to the Investment Advisers
Act of 1940, and have certain investment advisory agreements to manage private
investment funds. The revenue generated from these agreements is not material to
the Company's operations. See "Management's Discussion and Analysis -- Results
of Operations -- Comparison of Fiscal Years Ended December 31, 1998, 1997 and
1996."

LOAN SOURCING

During 1997 and 1998, we significantly increased the scope of our sales and
marketing activity by opening regional offices in Chicago and San Francisco. We
have also opened offices focused on small business lending in Detroit, Atlanta
and Philadelphia. We have a full-time sales and marketing staff dedicated to
identifying and pursuing mezzanine investments, commercial mortgage loans, and
SBA 7(a) loans. To source new investment opportunities, we work with thousands
of intermediaries including:

- regional and boutique investment banks;

- private mezzanine and equity investors;

- business and mortgage brokers;

- national retail financial services companies; and

- banks, law firms and accountants.

We believe that our experience and reputation provide a competitive
advantage in originating new investment opportunities. We have established an
extensive network of investment referral relationships over our 40-year history.
We are recognized as a pioneer in the mezzanine finance industry, and have
developed a reputation in the commercial real estate finance market for our
ability to finance complex transactions.

ASSET APPROVAL AND UNDERWRITING PROCESS

In assessing new investment opportunities, we maintain rigorous credit
standards based on our underwriting guidelines, a thorough due diligence
process, and a credit approval process requiring committee review, all of which
are described below. The combination of

41
<PAGE> 46

conservative underwriting standards and our credit-oriented culture has resulted
in a record of minimal realized losses.

GENERAL INVESTMENT CRITERIA. The following table highlights general
underwriting criteria for each product type. We use these criteria as general
guidelines only, and the characteristics of individual investments may vary
significantly depending upon each unique investment opportunity.

<TABLE>
<CAPTION>
MEZZANINE REAL ESTATE/SBA 7(a) LENDING
------------------------------- -------------------------------
<S> <C> <C>
INDUSTRY OR Consumer and industrial Office buildings, full service
PROPERTY products, business services hotels, manufacturing
TYPE (outsourcing), broadcasting, facilities, warehouses, retail
telecommunications, education, facilities, convenience stores,
and other industries that have gas stations, and other
low vulnerability to changes in properties requiring
economic cycles specialized underwriting
expertise

INVESTMENT Stable, growing companies, Amortization, collateral
CRITERIA strong cash flow, high returns coverage, cash flow coverage
on invested capital,
later-stage, strong management

LOAN SIZE $5 million to $25 million $0.2 million to $25 million

TERM 5 to 10 years 1 to 30 years

COLLATERAL Second lien on assets, if First lien on real estate,
available second lien on real estate,
personal guarantees
</TABLE>

LOAN UNDERWRITING PROCEDURES AND CRITERIA

MEZZANINE FINANCE. We generally consider financing companies that can
demonstrate strong market position, sales growth, positive cash flow, and
profitability. We emphasize the quality of management of our potential portfolio
companies, and specifically seek experienced entrepreneurs with a management
track record and relevant industry experience. We generally seek companies with
annual revenues of $20 million to $200 million, cash flow margins of greater
than 10% of revenues, operating histories of at least ten years, and seasoned
management teams who have a significant personal investment at risk in the
business. In addition, the business must generate a high return on its invested
capital, and must demonstrate a low level of vulnerability to changes in
economic cycles. The prospective portfolio company's total debt including our
loan is generally no greater than five times the company's current cash flow,
and the company's cash flow is generally no less than two times its total debt
service obligation to all of its lenders.

For each mezzanine financing, our investment professionals thoroughly
review, analyze and substantiate, through due diligence, the business plan and
operations of the potential portfolio company. Our financial due diligence,
which is often conducted with the assistance of an accounting firm, includes
analyzing the company's historical and projected financial information and
stress-testing the projections under adverse assumptions. Our business due
diligence, which is often conducted with the assistance of industry specialists
or consultants, thoroughly studies the industry and competitive landscape. We
assess the company's business plan and its cyclicality to assess the borrower's
ability to weather economic cycles. In management due diligence, we conduct
numerous personal and

42
<PAGE> 47

professional reference checks, including employees, both current and former,
customers, suppliers and competitors. The typical mezzanine financing will
require two to three months of diligence and structuring before funding occurs.

COMMERCIAL REAL ESTATE FINANCE AND SBA 7(a) LENDING. When we evaluate
commercial mortgage loans for origination or purchase, including CMBS purchases,
we generally receive an initial package of information that typically includes
underwriting information that was developed by the borrower or seller. Typical
underwriting information that we require from potential borrowers in order to
conduct appropriate due diligence includes: financial statements of the
borrower, appraisals, rent rolls and lease information, environmental reports,
structural and engineering reports, and any other information deemed appropriate
under the circumstances.

In the case of purchased loans, the seller generally provides financial
statements of the borrower, property appraisals and any other original
underwriting information. The seller also generally provides loan documents and
payment histories. When we originate or purchase commercial mortgage loans, we
generally consider a variety of other factors, including the borrower's
estimated current cash flow coverage, the creditworthiness of the borrower, the
net worth and financial strength of the borrower, the estimated current
liquidation value of the related mortgaged property, and trends in the
borrower's industry and in real estate values in the borrower's geographic
region. The loan officer inspects the property during the due diligence process,
and he or she values the property using internally developed valuation analyses.

Small businesses with less than 500 employees or less than $5 million in
annual sales qualify for SBA 7(a) loans. Our underwriting criteria are otherwise
very similar to our commercial mortgage loan criteria. We generally seek SBA
7(a) loans that are collateralized by real estate.

CREDIT APPROVAL PROCESS

All credit approval is obtained through a committee review process
centralized at our headquarters in Washington, DC. All of our lending
disciplines are represented on the investment committee, which is comprised of
our most senior lenders. The investment committee in its entirety, or certain
subcommittees of the investment committee, are required to approve all loan
transactions.

No one individual has the ability to approve a credit. The asset approval
process not only benefits from the experience of the investment committee
members, but also from the experience of our other investment professionals who,
on average, have over 13 years of professional experience. This experienced
staff of investment professionals underwrites each new loan and subjects each
potential investment to a rigorous due diligence process, as is described above.

In certain instances where risk/return characteristics warrant and for
every transaction larger than $10 million, we require approval from the
executive committee of the board of directors in addition to the investment
committee. Even after all such approvals are received, due diligence must be
successfully completed with final investment committee approval before funds are
disbursed to a new borrower.

43
<PAGE> 48

PORTFOLIO MANAGEMENT

LOAN SERVICING: Our staff is responsible for routine loan servicing, which
includes:

- payment processing;

- borrower inquiries;

- escrow analysis and processing;

- third-party reporting; and

- insurance and tax administration.

In addition, our staff is responsible for special servicing activities
including delinquency monitoring and collection, workout administration and
management of foreclosed assets.

PORTFOLIO MONITORING AND VALUATION: We use a grading system in order to
help us monitor our portfolio. The grading system assigns grades to investments
from 1 to 5 as follows:

<TABLE>
<CAPTION>
GRADE DESCRIPTION
- ----- -----------
<C> <S>
1 Probable capital gain
2 Performing security
3 Close monitoring -- no loss of principal or interest
expected
4 Workout -- some loss of interest expected
5 Workout -- some loss of principal and interest expected.
Security is valued at net realized value.
</TABLE>

At March 31, 1999 Grade 1 investments totaled $112.7 million, or 12.7% of
the total portfolio at value; Grade 2 investments totaled $700.6 million, or
79.1% of the total portfolio; Grade 3 investments totaled $39.7 million, or 4.5%
of the total portfolio; Grade 4 investments totaled $19.8 million, or 2.2% of
the total portfolio; and Grade 5 investments totaled $13.0 million or 1.5% of
the total portfolio.

As a BDC, the board of directors is required to value the portfolio on a
quarterly basis. In valuing each individual investment, we consider the
financial performance of each borrower, loan payment histories, indications of
potential equity realization events and current collateral values, and determine
whether the value of the asset should be increased through unrealized
appreciation or decreased through unrealized depreciation. After each investment
professional has made his or her determination of value, members of senior
management review the valuations. These valuations are then presented to the
board of directors for their review and approval.

As a general rule, the Company does not value its loans above cost, but
loans are subject to depreciation events when the asset is considered impaired.
Also as a general rule, equity securities may be assigned appreciation if
circumstances warrant. With respect to private equity securities, each
investment is valued using industry valuation benchmarks, and then the value is
assigned a discount reflecting the illiquid nature of the investment as well as
our minority, non-control position. When an external event such as a purchase
transaction, public offering, or subsequent equity sale occurs, the pricing
indicated by the external event is used to corroborate our private equity
valuation. Equity securities in public companies that carry certain restrictions
on sale are generally valued at a discount from the public market value of the
securities. Restricted and unrestricted publicly traded

44
<PAGE> 49

stocks may also be valued at discounts, due to the size of our investment or
market liquidity concerns.

DELINQUENCIES. We monitor loan delinquencies weekly. The following outlines
the treatment of each delinquency category:

30 DAYS PAST DUE............. Our loan servicing staff monitors loans and
contacts borrowers for collection.

60 DAYS PAST DUE............. We generally transfer loans to investment
professionals responsible for special servicing
activity for monitoring, collection, and
development of a workout plan, if necessary.

90 DAYS PAST DUE............. Our accounting department reviews loans in
conjunction with the investment professional
responsible for special servicing to determine
whether the loan should be placed on a
non-accrual status or whether a valuation
adjustment is required.

120 DAYS PAST DUE............ Generally, we place such loans on non-accrual
status and the loan is an active workout.

At March 31, 1999, $20.0 million, or 2.3% of the Company's portfolio at
value was 120 days or more past due. Included in this category are loans valued
at $8.4 million that are secured by real estate.

LOAN LOSSES. We have a history of low levels of loan losses, and have a
demonstrated track record of successfully resolving troubled credit situations
with minimal loss. The following table shows realized losses in the Company's
portfolio over the last five years:

<TABLE>
<CAPTION>
THREE MONTHS
ENDED MARCH 31, YEAR ENDED DECEMBER 31,
------------------- ----------------------------------------------------
1999 1998 1998 1997 1996 1995 1994
-------- -------- -------- -------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Realized Losses...... $ 348 $ -- $ 3,216 $ 5,100 $ 11,262 $ 4,679 $ 2,908
Total Assets..... 961,421 652,710 856,079 807,775 713,360 605,434 501,817
Realized Losses/Total
Assets............. -- -- 0.4% 0.6% 1.6% 0.8% 0.6%
</TABLE>

EMPLOYEES

At March 31, 1999, we employed 108 individuals including investment
professionals, operations professionals and administrative staff. All
individuals are located in the Washington, DC office, except for five
individuals in the Chicago office, four in the San Francisco office, four in the
Detroit office, one in the Atlanta office and two in the Philadelphia office. We
believe that our relations with employees are excellent.

LEGAL PROCEEDINGS

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

45
<PAGE> 50

PORTFOLIO COMPANIES

The following is a listing of our portfolio companies in which we had an
equity investment at March 31, 1999. We make available significant managerial
assistance to our portfolio companies. Other than loans to the portfolio
company, our only relationship with each portfolio company is our investment.
For information relating to the amount and general terms of our loans to
portfolio companies, see the Consolidated Statement of Investments and Notes
thereto at March 31, 1999 at pages F-5 to F-9.

<TABLE>
<CAPTION>
PERCENTAGE
NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS
OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1)
-------------------- ------------------ ------------------- -------------
<S> <C> <C> <C>
Acme Paging, L.P. ................ Paging Services Partnership Interests 1.8%
1336 Basswood, Suite F
Schaumburg, IL 60173
American Barbecue & Grill, Restaurant Chain 17.3%
Inc. ........................... Warrants to Purchase
7300 W. 110th Street, Suite 570 Common Stock
Overland Park, KS 66210
ASW Holding Corporation........... Steel Wool Manufacturer Warrants to Purchase 5.0%
2825 W. 31st Street Common Stock
Chicago, IL 60623
Au Bon Pain Co., Inc. ............ Restaurant Chain Warrants to Purchase 1.8%
19 Fid Kennedy Avenue Common Stock
Boston, MA 02210
Avborne, Inc. .................... Aviation Services Warrants to Purchase 2.5%
c/o Trivest, Inc. Company Common Stock
2665 S. Bayshore Dr., Suite 800
Miami, FL 33133-5462
Brazos Sportswear, Inc. .......... Sportswear Manufacturer Common Stock 7.8%
3860 Virginia Avenue & Distribution
Cincinnati, OH 45227
Candlewood Hotel Company.......... Extended Stay Series A Convertible 5.0%
9342 East Central Facilities Preferred Stock
Wichita, KS 67206
Celebrities, Inc. ................ Radio Stations Warrants to Purchase 25.0%
408-412 W. Oakland Park Common Stock
Boulevard
Ft. Lauderdale, FL 33311-1712
CeraTech Holdings Corporation..... Ceramic Plate Warrants to Purchase 33.7%
10435 Seymour Avenue Manufacturer Common Stock
Franklin Park, IL 60131
Cherry Tree Toys, Inc. ........... Direct Marketer of Common Stock 19.8%
7601 France Avenue South, #225 Woodcrafts
Edina, MN 55435
Convenience Corporation of
America......................... Convenience Store Chain Series A Preferred Stock 10.0%
711 N. 108th Court Warrants to Purchase 4.5%
Omaha, NE 68154 Common Stock
Cooper Natural Resources, Inc. ... Sodium Sulfate Producer Warrants to Purchase 25.3%
P.O. Box 1477 Common Stock
Seagraves, TX 79360
COHR, Inc......................... Healthcare Outsourcing Common Stock 15.6%
21540 Plummer Street
Chatsworth, CA 91311
</TABLE>

46
<PAGE> 51

<TABLE>
<CAPTION>
PERCENTAGE
NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS
OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1)
-------------------- ------------------ ------------------- -------------
<S> <C> <C> <C>
Cosmetic Manufacturing............ Cosmetic Manufacturer Options to Purchase 10.0%
Resources, LLC Shares
11312 Penrose Street
Sun Valley, CA 91352
Csabai Canning Factory Rt. ....... Food Processing Hungarian Quotas 9.2%
5600 Bekescasba
Bekis: vt 52-54 Hungary
DEH Printed Circuits, Inc. ....... Circuit Board Warrants to Purchase 12.5%
840 Church Road Manufacturer Common Stock
Elgin, IL 60123
DeVlieg-Bullard, Inc. ............ Tool Manufacturer Warrants to Purchase 1.7%
One Gorham Island Common Stock
Westport, CT 06680
Directory Investment Telephone Directories 50.0%
Corporation..................... Common Stock
1919 Pennsylvania Avenue, N.W.
Washington, DC 20006
Directory Lending Corporation..... Telephone Directories Common Stock 50.0%
1919 Pennsylvania Avenue, N.W.
Washington, DC 20006
EDM Consulting, LLC............... Environmental Common Stock 25.0%
14 Macopin Avenue Consulting
Montclair, NJ 07043
Enterprise Software, Inc.
(formerly IndeNet Corp.) ....... Broadcasting Software Common Stock 2.7%
5475 Tech Enter Drive, Suite 300 Warrants to Purchase 3.8%
Colorado Springs, CO 80919 Common Stock
Esquire Communications Ltd. ...... Court Reporting Warrants to Purchase 3.0%
216 E. 45th Street, 8th floor Services Common Stock
New York, NY 10017
ExTerra Credit Recovery, Inc. .... Consumer Finance Preferred Stock 2.6%
35 Lennon Lane, Suite 200 Common Stock 1.1%
Walnut Creek, CA 94598 Warrants to Purchase 1.1%
Common Stock
Fairchild Industrial Products
Company......................... Industrial Controls Warrants to Purchase 21.5%
3920 Westpoint Boulevard Manufacturer Common Stock
Winston-Salem, NC 27013
FTI Consulting, Inc. ............. Litigation Support Warrants to Purchase 7.5%
2021 Research Drive Services Common Stock
Annapolis, MD 21401
Galaxy American Communications,
LLC............................. Cable Television Warrants to Purchase 6%
1220 N. Main Street Operator Common Stock
Sikeston, MO 63801
Gibson Guitar Corporation ........ Guitar Manufacturer Warrants to Purchase 3.0%
1818 Elm Hill Pike Common Stock
Nashville, TN 37210
Ginsey Industries, Inc. .......... Toilet Seat 7.0%
Manufacturer Convertible Debentures
281 Benigno Boulevard Warrants to Purchase 16.0%
Bellmawr, NJ 08031 Common Stock
</TABLE>

47
<PAGE> 52

<TABLE>
<CAPTION>
PERCENTAGE
NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS
OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1)
-------------------- ------------------ ------------------- -------------
<S> <C> <C> <C>
Golden Eagle/Satellite
Archery, LLC.................... Sporting Equipment Convertible Debentures 26.9%
1733 Gunn Highway Manufacturer
Odessa, FL 33556
Grant Broadcasting System II...... Television Stations Warrants to Purchase 40.0%
919 Middle River Drive, Common Stock
Suite 409 Warrants to Purchase 40.0%
Ft. Lauderdale, FL 33304 Common Stock in
Affiliate Company
Grant Television, Inc. ........... Television Stations Warrants to Purchase 20.0%
(See Grant Broadcasting System II) Common Stock
Hotelevision, Inc. ............... Hotel Cable-TV Preferred Stock 14.2%
599 Lexington Avenue Network
Suite 2300
New York, NY 10022
Jack Henry & Associates, Inc. .... Commercial Banking Common Stock 0.5%
663 Highway 60 Software Development
P.O. Box 807
Monett, MO 65708
JRI Industries, Inc. ............. Machinery Manufacturer Warrants to Purchase 7.5%
2958 East Division Common Stock
Springfield, MO 65803
Julius Koch USA, Inc. ............ Cord Manufacturer Warrants to Purchase 45.0%
387 Church Street Common Stock
New Bedford, MA 02745
Kirker Enterprises, Inc. ......... Nail Enamel Warrants to Purchase 22.5%
55 East 6th Street Manufacturer Common Stock
Paterson, NJ 07524 Equity Interest in 5.0%
Affiliate Company
Kirkland's, Inc. ................. Home Furnishing Warrants to Purchase 3.2%
P.O. Box 7222 Retailer Common Stock
Jackson, TN 38308-7222
Kyrus Corporation
(formerly MidSouth Data
Systems, Inc.) ................. Value-Added Reseller, Warrants to Purchase 8.0%
25 Westridge Market Place Computer Systems Common Stock
Chandler, NC 28715
Liberty-Pittsburgh Systems, Business Forms Printing 20.0%
Inc. ........................... Common Stock
265 Executive Drive
Plainview, NY 11803
Love Funding Corporation.......... Mortgage Services Series D Preferred Stock 26.0%
1220 19th Street, NW, Suite 801
Washington, DC 20036
Midview Associates, L.P. ......... Residential Land Options to purchase 35.0%
2 Eaton Street, Suite 1101 Development partnership interests
Hampton, VA 23669
Mill-It Striping, Inc. ........... Highway Paint Striping Common Stock 8.0%
1005 Sunshine Lane
Altamonte Springs, FL 32714
Monitoring Solutions, Inc. ....... Air Emissions Common Stock 25.0%
4303 South High School Road Monitoring Warrants to Purchase 40.0%
Indianapolis, IN 46241 Common Stock
</TABLE>

48
<PAGE> 53

<TABLE>
<CAPTION>
PERCENTAGE
NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS
OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1)
-------------------- ------------------ ------------------- -------------
<S> <C> <C> <C>
Morton Industrial Group........... Friction Materials Common Stock 0.2%
5305 Oakbrook Parkway Manufacturer
Norcross, GA 30093
Nobel Learning Communities, Educational Services 100.0%
Inc. ........................... Series D Convertible
1400 N. Providence Road, Preferred Stock
Suite 3055 Warrants to Purchase 11.6%
Media, PA 19063 Common Stock
Nursefinders, Inc. ............... Home Healthcare Warrants to Purchase 3.5%
1200 Copeland Road, Suite 200 Providers Common Stock
Arlington, TX 76011
Old Mill Holdings, Inc............ Custom Embroidered Warrants to Purchase 24.0%
410 Severn Avenue, Suite 311 Apparel Manufacturer Common Stock
Annapolis, MD 21403
PIATL Holdings, Inc. ............. Asbestos Testing Labs Preferred Stock 35.5%
16000 Horizon Way, Suite 100 Common Stock 23.6%
Mt. Laurel, NJ 08054
Pico Products, Inc. .............. Satellite/Television Common Stock 5.0%
12500 Foothill Boulevard Component Warrants to Purchase 15.0%
Lakeview Terr., CA 91342 Manufacturer Common Stock
Precision Industrial Co. (formerly
Herr-Voss Industries, Inc.) .... Machinery Manufacturer Common Stock 8.5%
Arch Street Extension
Carnegie, PA 15106
Progressive International
Corporation .................... Retail Kitchenware Redeemable Preferred 6.2%
6111 S. 228th Street Stock
P.O. Box 97045 Warrants to Purchase 8.0%
Kent, WA 98064 Common Stock
Quality Software Products
Holdings, PLC................... Accounting Software Common Stock 0.7%
Talipot House 5th Avenue Developer
Gateshead Tyne & Wear, NE110XA
UNITED KINGDOM
Radio One, Inc. .................. Radio Stations Common Stock 3.7%
5900 Princess Garden Parkway
Lanham, MD 20706
Schwinn/GT........................ Bicycle Manufacturer/ Warrants to Purchase 0.7%
1690 38th Street Distributor Common Stock
Boulder, CO 80301
Seasonal Expressions, Inc......... Decorative Ribbon Series A Preferred Stock 100.0%
230 5th Avenue, Suite 1007 Manufacturer
New York, NY 10001
Spa Lending Corporation........... Health Spas Series A Preferred Stock 100.0%
1919 Pennsylvania Avenue, N.W. Series B Preferred Stock 68.4%
Washington, DC 20006 Series C Preferred Stock 46.3%
Common Stock 62.1%
Sydran Food Services II, LP....... Operator of Fast Options to Purchase 2.5%
Bishop Ranch 8 Food Restaurants Common Stock
3000 Executive Parkway
Ste. 515
San Ramon, CA 94583-4254
</TABLE>

49
<PAGE> 54

- ---------------
(1) Percentages shown for warrants and options held represent the percentage of
class of security we may own, on a fully diluted basis, assuming we exercise
our warrants or options.

DETERMINATION OF NET ASSET VALUE

We determine the net asset value per share of our common stock quarterly.
The net asset value per share is equal to the value of our total assets minus
liabilities and preferred stock divided by the total number of common shares
outstanding.

Portfolio assets are carried at fair value as determined by the board of
directors under the Company's valuation policy. As a general rule, the Company
does not value its loans above cost, but loans are subject to depreciation
events when the asset is considered impaired. Also as a general rule, equity
securities may be assigned appreciation if circumstances warrant. With respect
to private equity securities, each investment is valued using industry valuation
benchmarks, and then the value is assigned a discount reflecting the illiquid
nature of the investment as well as our minority, non-control position. When an
external event such as a purchase transaction, public offering, or subsequent
equity sale occurs, the pricing indicated by the external event is used to
corroborate our private equity valuation. Equity securities in public companies
that carry certain restrictions on sale are generally valued at a discount from
the public market value of the securities. Restricted and unrestricted publicly
traded stocks may also be valued at discounts, due to the size of our investment
or market liquidity concerns.

Determination of fair value involves subjective judgments that cannot be
substantiated by auditing procedures. Accordingly, under current standards, the
accountants' opinion on the Company's financial statements in our annual report
refers to the uncertainty with respect to the possible effect on the financial
statements of such valuation.

50
<PAGE> 55

MANAGEMENT

The board of directors supervises the management of our Company. The
responsibilities of each director include, among other things, the oversight of
the loan approval process, the quarterly valuation of our assets, and oversight
of our financing arrangements. The board of directors maintains an Executive
Committee, Audit Committee, Compensation Committee, and Nominating Committee,
and may establish additional committees in the future. All of the Company's
directors also serve as directors of its subsidiaries.

Our investment decisions are made by an investment committee comprised of
the Company's most senior investment professionals. The investment committee in
its entirety, or certain subcommittees of the investment committee, are required
to approve all loan transactions. No one person is primarily responsible for
making recommendations to the investment committee.

The Company is internally managed and our investment professionals manage
our portfolio and the portfolios of companies for which we serve as investment
adviser. These investment professionals have extensive experience in managing
investments in private growing businesses in a variety of industries and in
diverse geographic locations, and are familiar with our approach of lending and
investing. Because the Company is internally managed, we pay no investment
advisory fees, but instead we pay the operating costs associated with employing
investment management professionals.

STRUCTURE OF BOARD OF DIRECTORS

The Company's board of directors is classified into three approximately
equal classes with three-year terms, with only one of the three classes expiring
each year. Directors serve until their successors are elected and qualified.

DIRECTORS

Information regarding the board of directors is as follows:

<TABLE>
<CAPTION>
DIRECTOR EXPIRATION
NAME AGE POSITION SINCE(1) OF TERM
- ---- --- -------- -------- ----------
<S> <C> <C> <C> <C>
William L. Walton*........... 49 Chairman, Chief Executive
Officer and President 1986 2001
George C. Williams, Jr.*..... 72 Chairman Emeritus 1964 2001
Brooks H. Browne............. 49 Director 1990 2001
John D. Firestone............ 55 Director 1993 1999
Anthony T. Garcia............ 42 Director 1991 1999
Lawrence I. Hebert........... 52 Director 1989 1999
John I. Leahy................ 68 Director 1994 2000
Robert E. Long............... 68 Director 1972 2001
Warren K. Montouri........... 69 Director 1986 2000
Guy T. Steuart II............ 67 Director 1984 2000
T. Murray Toomey, Esq........ 75 Director 1959 2000
Laura W. van Roijen.......... 47 Director 1992 1999
</TABLE>

- ---------------
* Interested persons of the Company, as defined in the 1940 Act.

(1) Includes service as a director of any of the predecessor companies.

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<PAGE> 56

EXECUTIVE OFFICERS

Information regarding the Company's executive officers is as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
William L. Walton............ 49 Chairman, Chief Executive Officer and President
Philip A. McNeill............ 39 Managing Director
John M. Scheurer............. 46 Managing Director
Joan M. Sweeney.............. 39 Managing Director
G. Cabell Williams, III ..... 44 Managing Director
Penni F. Roll................ 33 Principal and Chief Financial Officer
</TABLE>

BIOGRAPHICAL INFORMATION

DIRECTORS

William L. Walton has been the Chairman, Chief Executive Officer and
President of the Company since 1997. Mr. Walton was President of Allied II from
1996 to 1997. Mr. Walton is the Chairman of Business Mortgage Investors, Inc
("BMI"), and is a director of Nobel Learning Communities, Inc. (a portfolio
company). Mr. Walton was Chief Executive Officer of Success Lab, Inc.
(children's educational services) from 1993 to 1996, and Chief Executive Officer
of Language Odyssey (educational publishing and services) from 1992 to 1996. Mr.
Walton was Managing Director of Butler Capital Corporation from 1987 to 1991.
Prior to that, Mr. Walton served as the investment advisor to William S. Paley,
founder and Chairman of CBS, from 1985 to 1987, and was an investment banker
with Lehman Brothers Kuhn Loeb from 1982 to 1985.

George C. Williams, Jr. is Chairman Emeritus of the Company. Mr. Williams
was an officer of the predecessor companies from the later of 1959 or the
inception of the relevant entity and President or Chairman and Chief Executive
Officer of the predecessor companies from the later of 1964 or each entity's
inception until 1991. Mr. Williams is a director of BMI. Mr. Williams is the
father of G. Cabell Williams III, an executive officer of the Company.

Brooks H. Browne has been the President of Environmental Enterprises
Assistance Fund since 1993. Mr. Browne was the President, Executive Vice
President or Senior Vice President of Advisers from 1984 to 1993. Mr. Browne is
a director of SEAF, Corporation Financiera Ambiental (Panama), Empresas
Ambientales de Centro America (Costa Rica) and Yayasan Bina Usaha Lingkungan
(Indonesia) (environmental nonprofit or investment funds).

John D. Firestone has been a Partner of Secor Group (venture capital) since
1978. Mr. Firestone is a director of BMI and Security Storage Company of
Washington, DC, and is a senior advisor to Gilbert Capital, Inc.

Anthony T. Garcia has been General Manager of Breen Capital Group (investor
in tax liens) since 1997. Mr. Garcia was a Senior Vice President of Lehman
Brothers Inc. from 1985 to 1996.

Lawrence I. Hebert has been a director of Riggs National Corporation since
1988. He also serves as a director of Riggs Investment Management Corporation
and Riggs Bank Europe Limited (indirect subsidiaries of Riggs National
Corporation). Mr. Hebert is the President and a director of Perpetual
Corporation (owner of Allbritton Communications Company and Allnewsco, Inc.) and
the Chairman and Chief Executive Officer of Allbrittan Communications Company
(owner of television stations). Mr. Hebert is a

52
<PAGE> 57

director of Allnewsco, Inc., the President of Westfield News Advertiser, Inc.,
and a trustee of The Allbritton Foundation. Mr. Hebert was Vice President of
University Bancshares, Inc. (a Texas bank holding company) from 1975 to 1997.

John I. Leahy has been the President of Management and Marketing Associates
(a management consulting firm) since 1986. Mr. Leahy was the President and Group
Executive Officer, Western Hemisphere of Black & Decker Corporation from 1982 to
1985. Mr. Leahy is a director of Kar Kraft Systems, Inc., Cavanaugh Capital,
Inc., Acorn Products, Inc., The Wills Group, Thulman-Eastern Company and
Gallagher Fluid Seals, Inc.

Robert E. Long is the Managing Director of Goodwyn & Long Investment
Management, Inc. Mr. Long has been the President and Chief Executive Officer of
Business News Network, Inc. since 1995, was the Chairman and Chief Executive
Officer of Southern Starr Broadcasting Group, Inc. from 1991 to 1995, and a
director and the President of Potomac Asset Management, Inc. from 1983 to 1991.
Mr. Long is a director of Ambase Inc., AHL Shipping Company, Inc., CSC
Scientific, Inc., and Global Travel, Inc.

Warren K. Montouri has been a Partner of Montouri & Roberson (real estate
investment firm) since 1980. Mr. Montouri was a director of C&S/Sovran Bank from
1970 to 1990, a director of Sovran Financial Corporation from 1989 to 1990, a
director of NationsBank, N.A. from 1990 to 1996, a trustee of Suburban Hospital
from 1991 to 1994, and a trustee of The Audubon Naturalist Society from 1979 to
1985. He has been a director of Franklin National Bank since 1996.

Guy T. Steuart II has been a director and President of Steuart Investment
Company (manages, operates, and leases real and personal property and holds
stock in operating subsidiaries engaged in various businesses) since 1960. Mr.
Steuart is Trustee Emeritus of Washington and Lee University.

T. Murray Toomey, Esq. has been an attorney at law since 1949. Mr. Toomey
is a director of The National Capital Bank of Washington, and Federal Center
Plaza Corporation. He is also a trustee of The Catholic University of America.

Laura W. van Roijen has been a private real estate investor since 1992. Ms.
van Roijen was the Chairman of CWV & Associates (RTC qualified contracting firm)
from 1991 to 1994, a director and the Treasurer of Black Possum Inc. (retail
concern) from 1994 to 1996, the President of Volta Place, Inc. (real estate
advisory firm) from 1991 to 1994, and Vice President (from 1986 to 1991) and
Market Director (from 1989 to 1991) of Citicorp Real Estate, Inc.

EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS

Philip A. McNeill, Managing Director, has been employed by the Company
since 1993.

John M. Scheurer, Managing Director, has been employed by the Company since
1991. Mr. Scheurer is also President of BMI.

Joan M. Sweeney, Managing Director, has been employed by the Company since
1993. Ms. Sweeney is also a Managing Director of BMI.

G. Cabell Williams, III, Managing Director, has been employed by the
Company since 1981. Mr. Williams is also a Managing Director of BMI.

53
<PAGE> 58

Penni F. Roll, Principal and Chief Financial Officer, has been employed by
the Company since 1995. Ms. Roll is also Principal and Chief Financial Officer
of BMI. Ms. Roll was a Manager at KPMG Peat Marwick, LLP from 1993 to 1995.

COMPENSATION PLANS

STOCK OPTION PLAN

The Company's stock option plan (the "New Plan") is intended to encourage
stock ownership in the Company by officers, thus giving them a proprietary
interest in the Company's performance. The Company's shareholders approved the
New Plan at the Special Meeting of Shareholders of Allied Lending held on
November 26, 1997. The principal objective of the Company's compensation
committee in awarding stock options to the Chief Executive Officer and other
eligible officers of the Company is to align each officer's interests with the
success of the Company and the financial interests of its shareholders. The
committee believes that the New Plan achieves this objective because it links a
portion of each executive's compensation with the performance of the Company's
stock and the value delivered to shareholders.

The committee grants stock options under the New Plan at a price not less
than the prevailing market value, and such options will have value only if the
Company's stock price increases. The committee determines the amount and
features of the stock options, if any, to be awarded to the Company's officers.
Historically, when granting stock options, the committee evaluated a number of
factors, including the recipient's current stock holdings, years of service,
position with the Company, and other factors. The committee has not applied a
formula assigning specific weights to any of these factors when making its
determination.

For the three months ended March 31, 1999 and for the year ended December
31, 1998, the Company's compensation committee granted a total of 30,000 and
5,189,944 options, respectively, net of cancellations, to certain officers of
the Company. These options generally vest over a five-year period. See "Control
Persons and Principal Holders of Securities" in the SAI for currently
exercisable options granted to certain executive officers. The Company filed an
application with the Commission to request approval to grant options under the
New Plan to non-officer directors. There can be no assurance that such approval
will be granted.

The New Plan is designed to satisfy the conditions of Section 422 of the
Code so that options granted under the New Plan may qualify as "incentive stock
options." To qualify as "incentive stock options," options may not become
exercisable for the first time in any year if the number of incentive options
first exercisable in that year multiplied by the exercise price exceeds
$100,000.

CUT-OFF AWARD AND FORMULA AWARD

Prior to the merger, each of the five predecessor companies had a stock
option plan (each, an "Old Plan" and collectively, the "Old Plans"). Each
predecessor company's compensation committee had granted options under the
applicable Old Plan to various employees of Advisers, who were also officers of
that predecessor company. In preparation for the merger, the Advisers'
compensation committee in conjunction with the compensation committees of the
other predecessor companies, determined that the five Old Plans should be
terminated upon the merger, so that the new merged Company would be able to
develop a new plan that would incent all officers and directors with a single
equity security. The existence of the Old Plans had resulted in certain
inequities in option grants among

54
<PAGE> 59

the various officers of the predecessor companies simply because of the
differences in the underlying equity securities. To balance stock option awards
among employees, and to account for the deviations caused by the existence of
five plans supported by five different publicly traded stocks, two special
awards were developed to be granted in lieu of options under the Old Plans that
were forgone upon completion of the merger and the cancellation of the Old
Plans.

CUT-OFF AWARD. The first award established a cut-off dollar amount as of
the date of the announcement of the merger (August 14, 1997) that was computed
for all outstanding, but unvested options that were canceled as of the date of
the merger (the "Cut-Off Award"). The Cut-Off Award was designed to cap the
appreciated value in unvested options at the merger announcement date in order
to set the foundation to balance option awards upon the merger. The Cut-Off
Award, in the aggregate, was computed to be $2.9 million, and is equal to the
difference between the market price of the shares of stock underlying the
canceled options under the Old Plans at August 14, 1997, less the exercise
prices of the options. The Cut-Off Award is payable for each canceled option as
the canceled option would have vested, and vests automatically in the event of a
change of control. The Cut-Off Award is payable only if the award recipient is
employed by the Company on the future vesting date. A table indicating the
Cut-Off Award for certain officers, and the related vesting schedule, is
contained in the SAI.

FORMULA AWARD. The second award (the "Formula Award") was designed to
compensate officers from the point when their unvested options ceased to
appreciate in value pursuant to the Cut-Off Award (i.e., August 14, 1997) up
until the time in which they are able to receive option awards in the Company
after the merger became effective. In the aggregate, the Formula Award equaled
six percent (6%) of the difference between the combined aggregate market
capitalizations of the predecessor companies as of the close of the market on
December 30, 1997, and the combined aggregate market capitalizations of the
predecessor companies on August 14, 1997. In total, the combined aggregate
market capitalization of the predecessor companies increased by $319 million
from August 14, 1997 to December 30, 1997, and the aggregate Formula Award was
approximately $19 million.

The Formula Award was designed as a long-term incentive compensation
program to be a replacement for canceled stock options and to balance share
ownership among key officers for past and prospective service. The terms of the
Formula Award required that the award be contributed to the Company's deferred
compensation plan, as discussed below, and be used to purchase shares of the
Company in the open market.

The Formula Award vests and accrues equally over a three-year period, on
the anniversary of the merger date (December 31, 1997), and vests automatically
in the event of a change of control of the Company. If an officer terminates
employment with the Company prior to the vesting of any part of the Formula
Award, that amount will be forfeited to the Company. Assuming all officers meet
the vesting requirement, the Company will accrue the Formula Award over the
three-year period in equal amounts of approximately $6.4 million less any
forfeitures. For the three months ended March 31, 1999 and for the year ended
December 31, 1998, $1.6 million and $6.2 million, respectively, was expensed for
the Formula Award. A table indicating the Formula Award for certain officers,
and the related vesting schedule, is contained in the SAI. For the three months
ended March 31, 1999 and for the year ended December 31, 1998, $61,000 and
$270,000, respectively, of the Formula Award was forfeited.

55
<PAGE> 60

On January 4, 1999, the trust that holds the deferred compensation plan
distributed shares of the Company's common stock with a value of $4,062,000
representing the portion of the Formula Award that vested on December 31, 1998.
These shares are held in restricted accounts at a brokerage firm.

EMPLOYEE STOCK OWNERSHIP PLAN

In connection with the merger, the Company adopted an amended and restated
Employee Stock Ownership Plan, or ESOP. All eligible employees (i.e., employees
with one (1) year of service who are at least 21 years of age) of the Company
are eligible participants in the ESOP. Pursuant to this qualified plan, during
1998 the Company contributed 5% of each eligible participant's total cash
compensation for the year, up to $160,000, to a plan account on the
participant's behalf, which fully vests over a two-year period. The contribution
with respect to compensation in excess of $160,000 is made to the deferred
compensation plan. The ESOP has used substantially all of these cash
contributions to purchase shares of the Company, thus aligning every employee's
interest with those of the Company and its shareholders. At March 31, 1999, the
ESOP held 0.5% of the outstanding shares of the Company, and the majority of
these shares had been allocated to participants' plan accounts.

DEFERRED COMPENSATION PLAN

Pursuant to the merger, the Company succeeded to the deferred compensation
plan of Advisers (the "Deferred Compensation Plan"), and subsequently adopted
such plan as amended and restated. The Deferred Compensation Plan is a funded
plan that provides for the deferral of compensation by the Company's employees
and consultants. Any employee or consultant of the Company is eligible to
participate in the plan at such time and for such period as the board of
directors designates. The Deferred Compensation Plan is administered through a
trust, and the Company funds this plan through cash contributions. The Deferred
Compensation Plan holds the unvested shares of the Company's common stock
purchased in connection with the Formula Award.

TAXATION

The following discussion is a general summary of the material federal
income tax considerations applicable to the Company and to an investment in the
common stock and does not purport to be a complete description of the income tax
considerations applicable to such an investment. The discussion is based upon
the Code, Treasury Regulations, and administrative and judicial interpretations
each as of the date of this prospectus and, all of which are subject to change.
You should consult your own tax advisor with respect to tax considerations which
pertain to your purchase of common stock.

This summary assumes that the investors in the Company hold shares as
capital assets. This summary does not discuss all aspects of federal income
taxation relevant to holders of the common stock in light of particular
circumstances, or to certain types of holders subject to special treatment under
federal income tax laws, including dealers in securities and financial
institutions. This summary does not discuss any aspects of foreign, state or
local tax laws.

TAXATION AS A RIC

The Company intends to be treated for tax purposes as a "regulated
investment company" or "RIC" within the meaning of Section 851 of the Code. If
the Company

56
<PAGE> 61

qualifies as a RIC and distributes to its shareholders in a timely manner at
least 90% of its "investment company taxable income," as defined in the Code
(the "90% Distribution Requirement"), each year, it will not be subject to
federal income tax on the portion of its taxable income and gains it distributes
to shareholders. In addition, if a RIC distributes in a timely manner (or treats
as "deemed distributed") 98% of its capital gain net income for each one year
period ending on December 31 (pursuant to Section 4982(e)(4)(A) of the Code),
and distributes 98% of its ordinary income for each calendar year, it will not
be subject to the 4% nondeductible federal excise tax on certain undistributed
income of RICs. The Company generally endeavors to distribute to shareholders
all of its investment company taxable income and its net capital gain, if any,
for each taxable year so that it will not incur income and excise taxes on its
earnings.

In order to qualify as a RIC for federal income tax purposes, the Company
must, among other things: (1) continue to qualify as a BDC under the 1940 Act;
(2) derive in each taxable year 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; and (3) diversify its holdings so that
at the end of each quarter of the taxable year (a) at least 50% of the value of
its assets consists of cash, cash items, U.S. 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 or 10% of the outstanding
voting securities of the issuer, and (b) no more than 25% of the value of the
Company's assets are invested in securities of one issuer (other than U.S.
government securities or securities of other RICs), or of two or more issuers
that are controlled by the Company and are engaged in the same or similar or
related trades or businesses. The failure of one or more of the Company's
subsidiaries to continue to qualify as RICs could adversely affect the Company's
ability to satisfy foregoing diversification requirements.

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 that year on all of its taxable income, regardless of whether it makes
any distribution to its shareholders. 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). In
contrast, as is explained below, if the Company qualifies as a RIC, a portion of
its distributions may be characterized as long-term capital gain in the hands of
shareholders.

TAXATION OF SHAREHOLDERS

Distributions of the Company generally are taxable to shareholders as
ordinary income or capital gains. Shareholders receive notification from the
Company at the end of each year as to the amount and nature of the income or
gains distributed to them for that year. The distributions from the Company to a
particular shareholder may be subject to the alternative minimum tax under the
provisions of the Code. Shareholders not subject to tax on income will not be
required to pay tax on amounts the Company distributed to them.

The Company's distributions of the ordinary income and net short-term
capital gain generally are taxable to shareholders as ordinary income.
Distributions of net capital gain, if any, that the Company designates as
capital gain dividends generally are taxable to shareholders as long-term
capital gain, regardless of the length of time a shareholder has held the
shares. All distributions are taxable, whether invested in additional shares or
received in cash. Dividends that the Company declares and are payable to
shareholders of record in October, November or December of a given year that are
paid during the

57
<PAGE> 62

following January, will be treated as having been received by shareholders on
December 31 of the year of declaration.

If certain conditions are met, the Company's ordinary income dividends to
its corporate shareholders may qualify for the dividends received deduction to
the extent that the Company receives qualifying dividend income during the
taxable year. Capital gain dividends distributed by the Company are not eligible
for the dividends received deduction.

In general, any gain or loss realized upon a taxable disposition of shares
of the Company, or upon receipt of a liquidating distribution, will be treated
as capital gain or loss. If gain is realized, it will be subject to taxation at
various tax rates depending on the length of time the taxpayer has held such
shares and other factors. The gain or loss will be short-term capital gain or
loss if the shares have been held for one year or less. If a shareholder has
received any capital gain dividends with respect to such shares, any loss
realized upon a taxable disposition of shares treated under the Code as having
been held for six months or less, to the extent of such capital gain dividends,
will be treated as a long-term capital loss. All or a portion of any loss
realized upon a taxable disposition of shares of the Company may be disallowed
if other shares of the Company are purchased (under a DRIP plan or otherwise)
within 30 days before or after the disposition.

A shareholder that is not a "United States person" within the meaning of
the Code (a "Non-U.S. shareholder") generally will be subject to a withholding
tax of 30% (or lower applicable treaty rate) on dividends from the Company
(other than capital gain dividends) that are not "effectively connected" with a
United States trade or business carried on by such shareholder. Accordingly,
investment in the Company is likely to be appropriate for a Non-U.S. shareholder
only if such person can utilize a foreign tax credit or corresponding tax
benefit in respect of such United States withholding tax. Non-effectively
connected capital gain dividends and gains realized from the sale of Shares will
not be subject to United States federal income tax in the case of (i) a Non-
U.S. shareholder that is a corporation and (ii) a Non-U.S. shareholder that is
not present in the United States for more than 182 days during the taxable year
(assuming that certain other conditions are met). See "Tax Status -- Non-U.S.
Stockholders" in the SAI. Prospective foreign investors should consult their
U.S. tax advisors concerning the tax consequences to them of an investment in
shares.

The Company is required to withhold and remit to the Internal Revenue
Service (the "IRS") 31% of the dividends paid to any shareholder who (i) fails
to furnish the Company with a certified taxpayer identification number; (ii) has
underreported dividend or interest income to the IRS; or (iii) fails to certify
to the Company that he, she or it is not subject to backup withholding.

CERTAIN GOVERNMENT REGULATIONS

We operate in a highly regulated environment. The following discussion
generally summarizes certain regulations.

BUSINESS DEVELOPMENT COMPANY ("BDC"). A business development company is
defined and regulated by the Investment Company Act of 1940. It is a unique kind
of investment company that focuses on investing in or lending to small private
companies and making managerial assistance available to them. A BDC may use
capital provided by public shareholders and from other sources to invest in
long-term, private investments in growing small businesses. A BDC provides
shareholders the ability to retain the liquidity of

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<PAGE> 63

a publicly traded stock, while sharing in the possible benefits, if any, of
investing in privately owned growth companies.

As a BDC, we may not acquire any asset other than "Qualifying Assets"
unless, at the time we make the acquisition, our Qualifying Assets represent at
least 70% of the value of our total assets (the "70% test"). The principal
categories of Qualifying Assets relevant to our business are:

(1) Securities purchased in transactions not involving any public offering,
the issuer of which is an eligible portfolio company. An eligible
portfolio company is defined to include any issuer that (a) is
organized and has its principal place of business in the United States,
(b) is not an investment company other than an SBIC wholly owned by a
BDC (our investments in Allied Investment, Allied SBLC and certain
other subsidiaries generally are Qualifying Assets), and (c) does not
have any class of publicly traded securities with respect to which a
broker may extend margin credit;

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

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

To include certain securities described above as Qualifying Assets for the
purpose of the 70% test, a BDC must make available to the issuer of those
securities significant managerial assistance such as providing 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 will provide managerial assistance on a continuing basis to any
portfolio company that requests it, whether or not difficulties are perceived.

As a BDC, the Company is entitled to issue senior securities in the form of
stock or senior securities representing indebtedness, as long as each class of
senior security has an asset coverage of at least 200% immediately after each
such issuance. This limitation is not applicable to borrowings by our SBIC or
SBLC subsidiaries, and therefore any borrowings by these subsidiaries are not
included in this asset coverage test. See "Risk Factors."

We may not change the nature of our business so as to cease to be, or
withdraw our election as, a BDC unless authorized by vote of a "majority of the
outstanding voting securities," as defined in the 1940 Act, of our shares. Since
we made our BDC election, we have not made any substantial change in the nature
of our business.

REGULATED INVESTMENT COMPANY ("RIC"). Our status as a RIC enables us to
avoid the cost of federal and state taxation, and as a result achieve pre-tax
investment returns. We believe that this tax advantage enables us to achieve
strong equity returns without having to aggressively leverage our balance sheet.

In order to qualify as a RIC, the Company must, among other things:

(1) 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.

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<PAGE> 64

(2) Diversify its holdings so that

(a) at least 50% of the value of the Company's assets consists of cash,
cash items, government securities 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 are invested
in securities of one issuer (other than U.S. government securities),
or of two or more issuers that are controlled by the Company.

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

SBA REGULATIONS. Allied Investment is an SBIC and Allied SBLC is an SBLC.

SBIC REGULATIONS. Allied Investment, a wholly owned subsidiary of the
Company, is licensed by the SBA as an SBIC under Section 301(c) of the Small
Business Investment Act of 1958, as amended (the "1958 Act"), and has elected to
be regulated as a BDC. Allied Investment resulted from the merger of the
Company's two wholly owned SBIC subsidiaries in July 1998. Pursuant to this
merger, the Company's subsidiary that was then named Allied Investment
Corporation merged with and into Allied Capital Financial Corporation ("Allied
Financial"). Allied Financial then changed its name to Allied Investment
Corporation ("Allied Investment"). Prior to the merger, Allied Financial was
licensed by the SBA as a Specialized Small Business Investment Company ("SSBIC")
under 301(d) of the 1958 Act. After the merger, Allied Investment could make
SBIC eligible investments in addition to SSBIC eligible investments.

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

Allied Investment is periodically examined and audited by the SBA staff to
determine its compliance with SBIC regulations.

Allied Investment has the opportunity to sell to the SBA subordinated
debentures with a maturity of up to ten years, up to an aggregate principal
amount of $101 million. This limit generally applies to all financial assistance
provided by the SBA to any licensee and its "associates," as that term is
defined in SBA regulations. Historically, an SBIC was

60
<PAGE> 65

also eligible to sell preferred stock to the SBA. Allied Investment had received
$47.7 million of subordinated debentures and $7.0 million of preferred stock
investments from the SBA at March 31, 1999; as a result of the $101 million
limit, the Company is limited on its ability to apply for additional financing
from the SBA. Interest rates on the SBA debentures currently outstanding have a
weighted average interest rate of 8.22%.

At March 31, 1999, we had an outstanding commitment from the SBA to
purchase up to $27.0 million in additional SBIC debentures. We may seek this
additional financing during 1999.

SBLC REGULATIONS. Allied SBLC is licensed to operate as an SBLC and is
periodically examined and audited by the SBA staff for purposes of determining
compliance with SBA regulations, including its participation in the Preferred
Lenders Program. See SBA 7(a) Lending, above.

DIVIDEND REINVESTMENT PLAN

We have adopted an "opt out" dividend reinvestment plan ("DRIP plan").
Under the DRIP plan, if you own shares registered in your own name, our transfer
agent, acting as reinvestment plan agent, will automatically reinvest any
dividend in additional shares of common stock. Shareholders may change
enrollment status in the DRIP plan at any time by contacting either the plan
agent or the Company.

A shareholder's ability to participate in a DRIP plan may be limited
according to how the shares are registered. A nominee may preclude beneficial
owners holding shares in street name from participating in the DRIP plan.
Shareholders who wish to participate in a DRIP plan may need to register their
shares in their own name. Shareholders will be informed of their right to opt
out of the DRIP plan in the Company's annual and quarterly reports to
shareholders. Shareholders who hold shares in the name of a nominee should
contact the nominee for details.

All distributions to investors who do not participate (or whose nominee
elects not to participate) in the DRIP plan will be paid by check mailed
directly, or through the nominee, to the record holder by or under the
discretion of the plan agent. The plan agent is American Stock Transfer and
Trust Company, 40 Wall Street, New York, New York 10005. Their telephone number
is 800-937-5449.

Under the DRIP plan, we may issue new shares unless the market price of the
outstanding shares is less than 110% of the last reported net asset value.
Alternatively, the plan agent may buy shares in the market. We value newly
issued shares for the DRIP plan at the average of the reported last sale prices
of the outstanding shares on the last five trading days prior to the payment
date of the distribution, but not less than 95% of the opening bid price on such
date. The price in the case of shares bought in the market will be the average
actual cost of such shares, including any brokerage commissions. There are no
other fees charged to shareholders in connection with the DRIP plan. Any
distributions reinvested under the plan will nevertheless remain taxable to the
shareholders.

DESCRIPTION OF CAPITAL STOCK

COMMON STOCK

The Company is authorized to issue 100,000,000 shares of common stock, par
value $0.0001. At April 30, 1999, there were 58,817,435 shares of common stock
outstanding

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<PAGE> 66

and 5,020,297 shares of Common Stock reserved for issuance under the New Plan.
The following are the authorized classes of securities of the Company as of
April 30, 1999:

<TABLE>
<CAPTION>
(4)
(3) AMOUNT
AMOUNT HELD OUTSTANDING
(2) BY COMPANY EXCLUSIVE OF
(1) AMOUNT OR FOR ITS AMOUNTS SHOWN
TITLE OF CLASS AUTHORIZED ACCOUNT* UNDER(3)
-------------- ----------- ----------- -------------
<S> <C> <C> <C> <C>
Allied Capital
Corporation........ Common Stock 100,000,000 563,537 58,253,898
</TABLE>

- -------------------------
* Represents shares of the Company held in a trust for the Deferred Compensation
Plan. See "Management -- Compensation Plans."

All shares of common stock have equal rights as to earnings, assets,
dividends, and voting privileges and all outstanding shares of common stock are
fully paid and non-assessable. Our common stock has no preemptive, conversion,
or redemption rights and are freely transferable. In the event of liquidation,
each share of common stock is entitled to its proportion of our assets after
debts and expenses. Each share is entitled to one vote and does not have
cumulative voting rights, which means that holders of a majority of the shares,
if they so choose, could elect all of the directors, and holders of less than a
majority of the shares would, in that case, be unable to elect any director. All
shares offered hereby will be, when issued and paid for, fully paid and
non-assessable.

The board of directors may classify and reclassify any unissued shares of
capital stock of the Company by setting or changing in one or more respects the
preferences, conversion or other rights, voting powers, restrictions,
limitations as to dividends, qualifications, terms or conditions or redemption
or other rights of such shares of capital stock.

LIMITATION ON LIABILITY OF DIRECTORS

The Company has adopted provisions in its charter and bylaws limiting the
liability of directors and officers of the Company for monetary damages. The
effect of these provisions in the charter and bylaws is to eliminate the rights
of the Company and its shareholders (through shareholders' derivative suits on
behalf of the Company) to recover monetary damages against a director or
officers for breach of the fiduciary duty of care as a director or officer
(including breaches resulting from negligent or grossly negligent behavior)
except in certain limited situations. These provisions do not limit or eliminate
the rights of the Company or any shareholder to seek non-monetary relief such as
an injunction or rescission in the event of a breach of a director's or
officer's duty of care. These provisions will not alter the liability of
directors or officers under federal securities laws.

CERTAIN ANTI-TAKEOVER PROVISIONS

The charter and bylaws of the Company and certain statutory and regulatory
requirements contain certain provisions that could make more difficult the
acquisition of the Company by means of a tender offer, a proxy contest or
otherwise. These provisions are expected to discourage certain types of coercive
takeover practices and inadequate takeover bids and to encourage persons seeking
to acquire control of the Company to negotiate first with the board of
directors. We believe that the benefits of these provisions outweigh the
potential disadvantages of discouraging such proposals because, among other
things, negotiation of such proposals might result in an improvement of their
terms. The

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<PAGE> 67

description set forth below is intended as a summary only and is qualified in
its entirety by reference to the charter and the bylaws.

CLASSIFIED BOARD OF DIRECTORS

The charter provides for the board of directors to be divided into three
classes of directors serving staggered three-year terms, with each class to
consist as nearly as possible of one-third of the directors then elected to the
board. A classified board may render more difficult a change in control of the
Company or removal of incumbent management. We believe, however, that the longer
time required to elect a majority of a classified board of directors helps to
ensure continuity and stability of the Company's management and policies.

ISSUANCE OF PREFERRED STOCK

The board of directors of the Company, without shareholder approval, has
the authority to reclassify common stock as preferred stock and to issue
preferred stock. Such stock could be issued with voting, conversion or other
rights designed to have an anti-takeover effect.

MARYLAND CORPORATE LAW

The Company is subject to the Maryland Business Combination Statute and the
Control Share Acquisition Statute, as defined below. The partial summary of the
foregoing statutes contained in this prospectus is not intended to be complete
and reference is made to the full text of such states for their entire terms.

BUSINESS COMBINATION STATUTE. Certain provisions of the Maryland Law
establish special requirements with respect to "business combinations" between
Maryland corporations and "interested shareholders" unless exemptions are
applicable (the "Business Combination Statute"). Among other things, the
Business Combination Statute prohibits for a period of five years a merger or
other specified transactions between a company and an interested shareholder and
requires a super majority vote for such transactions after the end of such
five-year period.

"Interested shareholders" are all persons owning beneficially, directly or
indirectly, 10% or more of the outstanding voting stock of a Maryland
corporation. "Business combinations" include certain mergers or similar
transactions subject to a statutory vote and additional transactions involving
transfer of assets or securities in specified amounts to interested shareholders
or their affiliates.

Unless an exemption is available, a "business combination" may not be
consummated between a Maryland corporation and an interested shareholder or its
affiliates for a period of five years after the date on which the shareholder
first became an interested shareholder and thereafter may not be consummated
unless recommended by the board of directors of the Maryland corporation and
approved by the affirmative vote of at least 80% of the votes entitled to be
cast by all holders of outstanding shares of voting stock and 66 2/3% of the
votes entitled to be cast by all holders of outstanding shares of voting stock
other than the interested shareholder or its affiliates or associates, unless,
among other things, the corporation's shareholders receive a minimum price (as
defined in the Business Combination Statute) for their shares and the
consideration is received in cash or in the same form as previously paid by the
interested shareholder for its shares.

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<PAGE> 68

A business combination with an interested shareholder which is approved by
the board of directors of a Maryland corporation at any time before an
interested shareholder first becomes an interested shareholder is not subject to
the five-year moratorium or special voting requirements. An amendment to a
Maryland corporation charter electing not to be subject to the foregoing
requirements must be approved by the affirmative vote of at least 80% of the
votes entitled to be cast by all holders of outstanding shares of voting stock
and 66 2/3% of the votes entitled to be cast by holders of outstanding shares of
voting stock who are not interested shareholders. Any such amendment is not
effective until 18 months after the vote of shareholders and does not apply to
any business combination of a corporation with a shareholder who became an
interested shareholder on or prior to the date of such vote.

CONTROL SHARE ACQUISITION STATUTE. The Maryland Law imposes limitations on
the voting rights of shares acquired in a "control share acquisition." The
control share statute defines a "control share acquisition" to mean the
acquisition, directly or indirectly, of "control shares" subject to certain
exceptions. "Control shares" of a Maryland corporation are defined to be voting
shares of stock which, if aggregated with all other shares of stock previously
acquired by the acquiror, would entitle the acquiror to exercise voting power in
electing directors with one of the following ranges of voting power:

(1) one-fifth or more but not less than one-third;

(2) one-third or more but less than a majority; or

(3) a majority of all voting power.

Control shares do not include shares which the acquiring person is entitled
to vote as a result of having previously obtained shareholder approval. Control
shares of a Maryland corporation acquired in a control share acquisition have no
voting rights except to the extent approved by a vote of two-thirds of the votes
entitled to be cast by shareholders in the election of directors, excluding
shares of stock as to which the acquiring person, officers of the corporation
and directors of the corporation who are employees of the corporation are
entitled to exercise or direct the exercise of the voting power of the shares in
the election of the directors.

The control share statute also requires Maryland corporations to hold a
special meeting at the request of an actual or proposed control share acquiror
generally within 50 days after a request is made with the submission of an
"acquiring person statement," but only if the acquiring person:

(1) gives a written undertaking and, if required by the directors of the
issuing corporation, posts a bond for the cost of the meeting; and

(2) submits definitive financing agreements for the acquisition of the
control shares to the extent that financing is not provided by the
acquiring person.

In addition, unless the issuing corporation's charter or bylaws provide
otherwise, the control share statute provides that the issuing corporation,
within certain time limitations, shall have the right to redeem control shares
(except those for which voting rights have previously been approved) for "fair
value" as determined pursuant to the control share statue in the event:

(1) there is a shareholder vote and the grant of voting rights is not
approved; or

(2) an "acquiring person statement" is not delivered to the target within
10 days following a control share acquisition.

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<PAGE> 69

Moreover, unless the issuing corporation's charter or bylaws provide
otherwise, the control share statute provides that if, before a control share
acquisition occurs, voting rights are accorded to control shares which result in
the acquiring person having majority voting power, then all shareholders other
than the acquiring person have appraisal rights as provided under the Maryland
Law. An acquisition of shares may be exempted from the control share statute
provided that a charter or bylaw provision is adopted for such purpose prior to
the control share acquisition by any person with respect to the Company. The
control share acquisition statute does not apply to shares acquired in a merger,
consolidation or share exchange to which the corporation is a party.

REGULATORY RESTRICTIONS

Allied Investment is an SBIC and Allied SBLC is an SBLC, and both are
wholly owned subsidiaries of the Company. The SBA prohibits, without prior SBA
approval, a "change of control" or transfers which would result in any person
(or group of persons acting in concert) owning 10% or more of any class of
capital stock of an SBIC. A "change of control" is any event which would result
in a transfer of the power, direct or indirect, to direct the management and
policies of an SBIC or SBLC, whether through ownership, contractual arrangements
or otherwise.

PLAN OF DISTRIBUTION

We may sell shares through underwriters or dealers, directly to one or more
purchasers, through agents or through a combination of any such methods of sale.
Any underwriter or agent involved in the offer and sale of shares will be named
in the applicable prospectus supplement.

The distribution of shares may be effected from time to time in one or more
transactions at a fixed price or prices, which may be changed, at prevailing
market prices at the time of sale, at prices related to such prevailing market
prices, or at negotiated prices, provided, however, that the offering price per
share, less any commissions or discounts, must equal or exceed the net asset
value ("NAV") per share of our common stock.

In connection with the sale of shares, underwriters or agents may receive
compensation from the Company or from purchasers of shares, for whom they may
act as agents, in the form of discounts, concessions or commissions.
Underwriters may sell shares to or through dealers and such dealers may receive
compensation in the form of discounts, concessions or commissions from the
underwriters and/or commissions from the purchasers for whom they may act as
agents. Underwriters, dealers and agents that participate in the distribution of
shares may be deemed to be underwriters under the Securities Act, and any
discounts and commissions they receive from the Company and any profit realized
by them on the resale of shares may be deemed to be underwriting discounts and
commissions under the Securities Act. Any such underwriter or agent will be
identified and any such compensation received from the Company will be described
in the applicable prospectus supplement.

Any shares sold pursuant to a prospectus supplement will be quoted on the
Nasdaq National Market, or another exchange on which the shares are traded.

Under agreements into which the Company may enter, underwriters, dealers
and agents who participate in the distribution of shares may be entitled to
indemnification by the Company against certain liabilities, including
liabilities under the Securities Act.

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<PAGE> 70

Underwriters, dealers and agents may engage in transactions with, or
perform services for, the Company in the ordinary course of business.

If so indicated in the applicable prospectus supplement, the Company will
authorize underwriters or other persons acting as the Company's agents to
solicit offers by certain institutions to purchase shares from the Company
pursuant to contracts providing for payment and delivery on a future date.
Institutions with which such contracts may be made include commercial and
savings banks, insurance companies, pension funds, investment companies,
educational and charitable institutions and others, but in all cases such
institutions must be approved by the Company. The obligations of any purchaser
under any such contract will be subject to the condition that the purchase of
shares shall not at the time of delivery be prohibited under the laws of the
jurisdiction to which such purchaser is subject. The underwriters and such other
agents will not have any responsibility in respect of the validity or
performance of such contracts. Such contracts will be subject only to those
conditions set forth in the prospectus supplement, and the prospectus supplement
will set forth the commission payable for solicitation of such contracts.

In order to comply with the securities laws of certain states, if
applicable, shares offered hereby will be sold in such jurisdictions only
through registered or licensed brokers or dealers. In addition, in certain
states, the shares may not be sold unless they have been registered or qualified
for sale in the applicable state or an exemption from the registration or
qualification requirement is available and is complied with.

LEGAL MATTERS

Certain legal matters with respect to the validity of the shares of common
stock offered hereby will be passed upon for the Company by Sutherland Asbill &
Brennan LLP, Washington, D.C. Certain legal matters will be passed upon for
underwriters, if any, by the counsel named in the prospectus supplement.

SAFEKEEPING, TRANSFER AND DIVIDEND PAYING AGENT
AND REGISTRAR

The Company's and its subsidiaries' investments are held in safekeeping by
Riggs Bank, N.A. at 808 17th Street, N.W., Washington, D.C. 20006. LaSalle
National Bank, located at 25 Northwest Point Boulevard, Suite 800, Elk Grove
Village, Illinois 60007, serves as trustee with respect to assets of the Company
held for securitization purposes. American Stock Transfer and Trust Company, 40
Wall Street, 46th Floor, New York, New York 10005 acts as the Company's
transfer, dividend paying and reinvestment plan agent and registrar.

INDEPENDENT PUBLIC ACCOUNTANTS

The financial statements included in this prospectus and elsewhere in the
registration statement to the extent and for the periods indicated in their
report have been audited by Arthur Andersen LLP, independent public accountants,
as indicated in their report with respect thereto, and is included in this
prospectus with their consent.

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<PAGE> 71

TABLE OF CONTENTS OF
STATEMENT OF ADDITIONAL INFORMATION

<TABLE>
<S> <C>
General Information and History............................. B-2
Investment Objective and Policies........................... B-2
Management.................................................. B-2
Compensation of Executive Officers and Directors....... B-2
Compensation of Directors.............................. B-3
Stock Option Awards.................................... B-4
Cut-off Award and Formula Award........................ B-4
Committees of the Board of Directors................... B-6
Control Persons and Principal Holders of Securities......... B-7
Investment Advisory Services................................ B-8
Safekeeping, Transfer and Dividend Paying Agent and
Registrar................................................. B-8
Accounting Services......................................... B-8
Brokerage Allocation and Other Practices.................... B-8
Tax Status.................................................. B-9
</TABLE>

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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS

INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Consolidated Balance Sheet -- March 31, 1999 (unaudited) and
December 31, 1998 and 1997................................ F-1
Consolidated Statement of Operations -- For the Three Months
Ended March 31, 1999 and 1998 (unaudited) and for the
Years Ended December 31, 1998, 1997 and 1996.............. F-2
Consolidated Statement of Changes in Net Assets -- For the
Three Months Ended March 31, 1999 and 1998 (unaudited) and
for the Years Ended December 31, 1998, 1997 and 1996...... F-3
Consolidated Statement of Cash Flows -- For the Three Months
Ended March 31, 1999 and 1998 (unaudited) and for the
Years Ended December 31, 1998, 1997 and 1996.............. F-4
Consolidated Statement of Investments -- March 31, 1999
(unaudited) and December 31, 1998......................... F-5
Notes to Consolidated Financial Statements.................. F-15
Report of Independent Public Accountants.................... F-36
</TABLE>

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<PAGE> 73

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET

<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
----------- -------------------
1999 1998 1997
----------- -------- --------
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) (UNAUDITED)
<S> <C> <C> <C>
ASSETS
Portfolio at value:
Mezzanine loans and debt securities (cost:
1999-$368,776; 1998-$354,870; 1997-$181,184)........ $351,578 $339,163 $167,842
Commercial mortgage loans (cost: 1999-$210,553;
1998-$232,745; 1997-$446,114)....................... 210,865 233,186 447,244
Commercial mortgage-backed securities (cost:
1999-$202,283; 1998-$115,174; 1997-$0).............. 200,783 113,674 --
Small Business Administration 7(a) loans (cost:
1999-$58,985; 1998-$57,651; 1997-$41,103)........... 58,290 56,285 40,709
Equity interests in portfolio companies (cost:
1999-$28,013; 1998-$27,618; 1997-$20,050)........... 55,911 49,391 39,906
Other portfolio assets (cost: 1999-$8,639;
1998-$8,331; 1997-$2,269)........................... 8,411 8,575 1,320
-------- -------- --------
Total portfolio at value.......................... 885,838 800,274 697,021
-------- -------- --------
Cash and cash equivalents................................... 35,231 25,075 70,437
U.S. government securities.................................. -- -- 11,091
Other assets................................................ 40,352 30,730 29,226
-------- -------- --------
Total assets...................................... $961,421 $856,079 $807,775
======== ======== ========

LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Debentures and notes payable.......................... $289,742 $239,350 $308,821
Revolving lines of credit............................. 121,000 95,000 38,842
Accounts payable and other liabilities................ 20,703 27,912 23,984
Dividends and distributions payable................... -- 1,700 9,068
-------- -------- --------
Total liabilities................................. 431,445 363,962 380,715
-------- -------- --------
Commitments and Contingencies
Preferred stock issued to Small Business Administration..... 7,000 7,000 7,000
Shareholders' equity:
Common stock, $0.0001 par value, 100,000,000 shares
authorized; 58,817,435, 56,729,502 and 52,047,318
issued and outstanding at March 31, 1999, December
31, 1998 and 1997, respectively..................... 6 6 5
Additional paid-in capital............................ 563,853 526,824 451,044
Common stock held in deferred compensation trust
(563,537 shares and 810,456 shares at March 31, 1999
and December 31, 1998, respectively)................ (13,622) (19,431) --
Notes receivable from sale of common stock............ (23,735) (23,735) (29,611)
Net unrealized appreciation on portfolio.............. 6,663 2,380 1,301
Distributions in excess of earnings................... (10,189) (927) (2,679)
-------- -------- --------
Total shareholders' equity........................ 522,976 485,117 420,060
-------- -------- --------
Total liabilities and shareholders' equity........ $961,421 $856,079 $807,775
======== ======== ========
</TABLE>

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

F-1
<PAGE> 74

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS

<TABLE>
<CAPTION>
FOR THE THREE
MONTHS
ENDED MARCH 31, FOR THE YEARS ENDED DECEMBER 31,
------------------- ---------------------------------
1999 1998 1998 1997 1996
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) -------- -------- --------- --------- ---------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Interest and related portfolio income:
Interest................................. $24,684 $19,501 $79,921 $86,882 $77,541
Net premiums from loan dispositions...... 1,901 1,336 5,949 7,277 4,241
Net gain on securitization of commercial
mortgage loans......................... -- 14,812 14,812 -- --
Investment advisory fees and other
income................................. 1,093 1,248 6,056 3,246 3,155
------- ------- ------- ------- -------
Total interest and related portfolio
income............................. 27,678 36,897 106,738 97,405 84,937
------- ------- ------- ------- -------
Expenses:
Interest on indebtedness................. 6,365 4,598 20,694 26,952 20,298
Salaries and employee benefits........... 3,361 2,850 11,829 10,258 8,774
General and administrative............... 2,350 2,757 11,921 8,970 8,289
Merger................................... -- -- -- 5,159 --
------- ------- ------- ------- -------
Total operating expenses............. 12,076 10,205 44,444 51,339 37,361
Formula and cut-off awards............... 1,772 1,772 7,049 -- --
------- ------- ------- ------- -------
Portfolio income before net realized and
unrealized gains............................. 13,830 24,920 55,245 46,066 47,576
------- ------- ------- ------- -------
Net realized and unrealized gains:
Net realized gains....................... 466 6,421 22,541 10,704 19,155
Net unrealized gains (losses)............ 4,284 724 1,079 7,209 (7,412)
------- ------- ------- ------- -------
Total net realized and unrealized
gains.............................. 4,750 7,145 23,620 17,913 11,743
------- ------- ------- ------- -------
Income before minority interests and income
taxes........................................ 18,580 32,065 78,865 63,979 59,319
Minority interests............................. -- -- -- 1,231 2,427
Income tax expense............................. -- -- 787 1,444 1,945
------- ------- ------- ------- -------
Net increase in net assets resulting from
operations................................... $18,580 $32,065 $78,078 $61,304 $54,947
======= ======= ======= ======= =======
Basic earnings per common share................ $ 0.33 $ 0.62 $ 1.50 $ 1.24 $ 1.19
======= ======= ======= ======= =======
Diluted earnings per common share.............. $ 0.33 $ 0.61 $ 1.50 $ 1.24 $ 1.17
======= ======= ======= ======= =======
Weighted average common shares
outstanding -- basic......................... 56,799 51,814 51,941 49,218 46,172
======= ======= ======= ======= =======
Weighted average common shares
outstanding -- diluted....................... 56,828 52,108 51,974 49,251 46,733
======= ======= ======= ======= =======
</TABLE>

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

F-2
<PAGE> 75

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS

<TABLE>
<CAPTION>
FOR THE THREE MONTHS
ENDED MARCH 31, FOR THE YEARS ENDED DECEMBER 31,
--------------------- ---------------------------------
1999 1998 1998 1997 1996
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
<S> <C> <C> <C> <C> <C>
Operations:
Portfolio income before realized and
unrealized gains................... $ 13,830 $ 24,920 $ 55,245 $ 46,066 $ 47,576
Net realized gains................... 466 6,421 22,541 10,704 19,155
Net unrealized gains (losses)........ 4,284 724 1,079 7,209 (7,412)
Minority interests and income tax
expense............................ -- -- (787) (2,675) (4,372)
-------- -------- -------- -------- --------
Net increase in net assets
resulting from operations..... 18,580 32,065 78,078 61,304 54,947
-------- -------- -------- -------- --------
Shareholder distributions:
Portfolio income..................... (23,505) (18,225) (49,397) (38,751) (39,030)
Excess of portfolio income........... -- -- -- (605) (2,533)
Net capital gains.................... -- -- (24,976) (15,172) (11,546)
Excess of net capital gains.......... -- -- (714) -- --
Return of capital.................... -- -- -- (22,302) (4,289)
Undistributed earnings............... -- -- -- (8,848) --
Preferred stock dividend............. (55) (55) (230) (220) (220)
-------- -------- -------- -------- --------
Net decrease in net assets
resulting from shareholder
distributions................. (23,560) (18,280) (75,317) (85,898) (57,618)
-------- -------- -------- -------- --------
Capital share transactions:
Sale of common stock................. 35,787 -- 69,675 -- 22,365
Net decrease (increase) in notes
receivable from sale of common
stock.............................. -- 3,055 5,576 (14,120) (8,176)
Issuance of common stock upon the
exercise of stock options.......... -- -- 221 28,426 12,176
Issuance of common stock in lieu of
cash distributions................. 1,243 1,678 6,184 26,612 11,986
Purchase of common stock by deferred
compensation trust................. -- (15,330) (19,431) -- --
Distribution of common stock by
deferred compensation trust........ 5,748 -- -- -- --
Other................................ 61 -- 71 1,602 (738)
-------- -------- -------- -------- --------
Net increase (decrease) in net
assets resulting from capital
share transactions............ 42,839 (10,597) 62,296 42,520 37,613
-------- -------- -------- -------- --------
Total increase in net assets.............. $ 37,859 $ 3,188 $ 65,057 $ 17,926 $ 34,942
-------- -------- -------- -------- --------
Net assets at beginning of year........... $485,117 $420,060 $420,060 $402,134 $367,192
-------- -------- -------- -------- --------
Net assets at end of year................. $522,976 $423,248 $485,117 $420,060 $402,134
======== ======== ======== ======== ========
Net asset value per common share.......... $ 8.98 $ 8.23 $ 8.68 $ 8.07 $ 8.34
======== ======== ======== ======== ========
Common shares outstanding at end of
year.................................... 58,254 51,451 55,919 52,047 48,238
======== ======== ======== ======== ========
</TABLE>

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

F-3
<PAGE> 76

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS

<TABLE>
<CAPTION>
FOR THE THREE MONTHS
ENDED MARCH 31, FOR THE YEARS ENDED DECEMBER 31,
-------------------- ---------------------------------
1999 1998 1998 1997 1996
-------- --------- --------- --------- ---------
(IN THOUSANDS) (UNAUDITED)
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net increase in net assets resulting from
operations................................. $ 18,580 $ 32,065 $ 78,078 $ 61,304 $ 54,947
Adjustments
Net unrealized (gains) losses.............. (4,284) (724) (1,079) (7,209) 7,412
Net gain on securitization of commercial
mortgage loans........................... -- (14,812) (14,812) -- --
Depreciation and amortization.............. 1,450 173 702 450 393
Amortization of loan discounts and fees.... (1,150) (1,349) (6,032) (10,804) (9,027)
Deferred income taxes...................... -- -- -- 1,087 (381)
Minority interests......................... -- -- -- 1,231 2,427
Changes in other assets and liabilities.... (10,080) (4,228) 11,998 12,881 (10,606)
-------- --------- --------- --------- ---------
Net cash provided by operating
activities............................ 4,516 11,125 68,855 58,940 45,165
-------- --------- --------- --------- ---------
Cash flows from investing activities:
Investments in small business concerns....... (159,380) (107,506) (524,530) (364,942) (283,295)
Collections of investment principal.......... 37,321 30,773 138,081 233,005 179,292
Proceeds from loan sales..................... 40,467 9,706 81,013 53,912 27,715
Proceeds from securitization of commercial
mortgage loans............................. -- 223,401 223,401 -- --
Net redemption (purchase) of U.S. government
securities................................. -- (13,987) 11,091 (10,301) --
Collections of notes receivable from sale of
common stock............................... -- 3,055 5,591 6,534 2,199
Other investing activities................... (931) (3,804) (2,539) (182) 2,635
-------- --------- --------- --------- ---------
Net cash (used in) provided by investing
activities............................ (82,523) 141,638 (67,892) (81,974) (71,454)
-------- --------- --------- --------- ---------
Cash flows from financing activities:
Sale of common stock......................... 35,787 -- 69,896 8,615 24,166
Purchase of common stock by deferred
compensation trust......................... -- (15,330) (19,431) -- --
Common dividends and distributions paid...... (23,959) (16,547) (69,536) (58,194) (47,089)
Special undistributed earnings distribution
paid....................................... -- (8,848) (8,848) -- --
Preferred stock dividends.................... (55) (275) (450) (220) (220)
Net (payments on) borrowings under debentures
and notes payable.......................... 50,390 (209,578) (69,471) 78,923 (35,202)
Net borrowings under (payments on) revolving
lines of credit............................ 26,000 64,158 56,158 (6,257) 110,460
Other financing activities................... -- (5,767) (4,643) (1,237) (3,029)
-------- --------- --------- --------- ---------
Net cash (used in) provided by financing
activities............................ 88,163 (192,187) (46,325) 21,630 49,086
-------- --------- --------- --------- ---------
Net (decrease) increase in cash and cash
equivalents.................................. $ 10,156 $ (39,424) $ (45,362) $ (1,404) $ 22,797
Cash and cash equivalents at beginning of
period....................................... $ 25,075 $ 70,437 $ 70,437 $ 71,841 $ 49,044
-------- --------- --------- --------- ---------
Cash and cash equivalents at end of period..... $ 35,231 $ 31,013 $ 25,075 $ 70,437 $ 71,841
======== ========= ========= ========= =========
</TABLE>

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

F-4
<PAGE> 77

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INVESTMENTS

Acme Paging, L.P. Debt Securities $ 6,355 $ 6,355
Partnership Interest 1,456 2,600
- -----------------------------------------------------------------------------------------------------
American Barbecue & Grill, Inc. Warrants 125 125
- -----------------------------------------------------------------------------------------------------
AMF Bowling, Inc. (1) High Yield Debt 5,557 5,557
- -----------------------------------------------------------------------------------------------------
ASW Holding Corporation Warrants 25 25
- -----------------------------------------------------------------------------------------------------
Au Bon Pain Co., Inc. (1) Debt Securities 7,441 7,441
Warrants 227 --
- -----------------------------------------------------------------------------------------------------
Avborne, Inc. Debt Securities 11,510 11,510
Warrants 1,000 1,000
- -----------------------------------------------------------------------------------------------------
Brazos Sportswear, Inc. (1) Common Stock (342,938 shares) 330 --
- -----------------------------------------------------------------------------------------------------
Candlewood Hotel Company (1) Preferred Stock (3,250 shares) 3,250 3,250
- -----------------------------------------------------------------------------------------------------
Celebrities, Inc. Debt Securities 332 332
Warrants 12 12
- -----------------------------------------------------------------------------------------------------
CeraTech Holdings Corporation Debt Securities 1,991 50
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Cherry Tree Toys, Inc. Debt Securities 1,610 1,406
Common Stock (220 shares) 1 --
- -----------------------------------------------------------------------------------------------------
COHR, Inc. (1) Debt Securities 20,000 20,000
Common Stock (277,778 shares) 1,000 1,000
- -----------------------------------------------------------------------------------------------------
Convenience Corporation of Debt Securities 8,391 2,774
America Series A Preferred Stock (31,521 shares) 334 --
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Cooper Natural Resources, Inc. Debt Securities 3,453 3,453
Warrants -- 1,138
- -----------------------------------------------------------------------------------------------------
CorrFlex Graphics, LLC Loan 5,909 5,909
- -----------------------------------------------------------------------------------------------------
Cosmetic Manufacturing Debt Securities 2,950 2,950
Resources, LLC Options -- --
- -----------------------------------------------------------------------------------------------------
Coverall North America Loan 8,917 8,917
- -----------------------------------------------------------------------------------------------------
Csabai Canning Factory Rt. Hungarian Quotas (9.2%) 700 350
- -----------------------------------------------------------------------------------------------------
DEH Printed Circuits, Inc. Warrants 250 --
- -----------------------------------------------------------------------------------------------------
DeVlieg-Bullard, Inc. (1) Warrants 350 107
- -----------------------------------------------------------------------------------------------------
Directory Investment Corporation Common Stock (470 shares) -- --
- -----------------------------------------------------------------------------------------------------
Directory Lending Corporation Series A Common Stock (34 shares) -- --
Series B Common Stock (6 shares) 8 --
Series C Common Stock (10 shares) 22 --
- -----------------------------------------------------------------------------------------------------
Drilltec Patents & Technologies Loan 10,139 8,981
Company, Inc.
- -----------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-5
<PAGE> 78

<TABLE>
<CAPTION>
PORTFOLIO COMPANY MARCH 31, 1999
(IN THOUSANDS, EXCEPT NUMBER -------------------
OF SHARES) INVESTMENT(2) COST VALUE
- --------------------------------- --------------------------------------------- -------- --------
(UNAUDITED)
<S> <C> <C> <C>
ECM Enterprises Loan $ 29 $ 4
- -----------------------------------------------------------------------------------------------------
EDM Consulting, LLC Loans 14 14
Debt Securities 1,875 540
Common Stock (100 shares) 250 --
- -----------------------------------------------------------------------------------------------------
El Dorado Communications, Inc. Loans 306 306
- -----------------------------------------------------------------------------------------------------
Enterprise Software, Inc. (1) Debt Securities 14,880 14,880
Common Stock (147,975 shares) 1,176 852
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Eparfin S.A. Loan 29 29
- -----------------------------------------------------------------------------------------------------
Esquire Communications Ltd. (1) Warrants 6 --
- -----------------------------------------------------------------------------------------------------
Everything Yogurt Loan 25 25
- -----------------------------------------------------------------------------------------------------
Ex Terra Credit Recovery, Inc. Series A Preferred Stock (500 shares) 497 497
Common Stock (2,500 shares) 3 3
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Fairchild Industrial Products Debt Securities 5,714 5,714
Company Warrants 280 3,628
- -----------------------------------------------------------------------------------------------------
FHM Distributions, Inc. Loans 200 200
- -----------------------------------------------------------------------------------------------------
FTI Consulting, Inc. (1) Debt Securities 12,740 12,740
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Galaxy American Debt Securities 30,712 30,712
Communications, LLC Warrants -- --
- -----------------------------------------------------------------------------------------------------
Genoa Mine Acquisition Loan 242 242
Corporation
- -----------------------------------------------------------------------------------------------------
Gibson Guitar Corporation Debt Securities 15,243 15,243
Warrants 525 1,000
- -----------------------------------------------------------------------------------------------------
Ginsey Industries, Inc. Loans 5,000 5,000
Convertible Debentures 500 500
Warrants -- 154
- -----------------------------------------------------------------------------------------------------
Golden Eagle/Satellite Loans 1,390 1,390
Archery, LLC Convertible Debentures 2,248 2,242
- -----------------------------------------------------------------------------------------------------
Grant Broadcasting System II Warrants 139 7,338
- -----------------------------------------------------------------------------------------------------
Grant Television, Inc. Debt Securities 9,159 9,159
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Han Hie Loan 508 508
- -----------------------------------------------------------------------------------------------------
Hotelevision, Inc. Preferred Stock (1,000,000 shares) 1,000 1,000
- -----------------------------------------------------------------------------------------------------
Jack Henry & Associates, Inc. (1) Common Stock (90,438 shares) 26 3,099
- -----------------------------------------------------------------------------------------------------
Jeff & Chris Mufflers, Inc. Loan 83 83
- -----------------------------------------------------------------------------------------------------
JRI Industries, Inc. Debt Securities 2,120 2,120
Warrants 74 74
- -----------------------------------------------------------------------------------------------------
Julius Koch USA, Inc. Debt Securities 4,708 4,708
Warrants 324 2,700
- -----------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-6
<PAGE> 79

<TABLE>
<CAPTION>
PORTFOLIO COMPANY MARCH 31, 1999
(IN THOUSANDS, EXCEPT NUMBER -------------------
OF SHARES) INVESTMENT(2) COST VALUE
- --------------------------------- --------------------------------------------- -------- --------
(UNAUDITED)
<S> <C> <C> <C>
Kirker Enterprises, Inc. Warrants $ 348 $ 3,500
Equity Interest 5 5
- -----------------------------------------------------------------------------------------------------
Kirkland's, Inc. Debt Securities 6,291 6,291
Warrants 96 2,850
- -----------------------------------------------------------------------------------------------------
Kyrus Corporation Debt Securities 7,616 7,616
Warrants 348 348
- -----------------------------------------------------------------------------------------------------
Liberty-Pittsburgh Systems, Inc. Debt Securities 3,411 3,411
Common Stock (64,535 shares) 142 142
- -----------------------------------------------------------------------------------------------------
Lingcomm, Inc. Loan 207 207
- -----------------------------------------------------------------------------------------------------
Liqui-Dri Foods, Inc. Loans 10,412 10,412
- -----------------------------------------------------------------------------------------------------
The Loewen Group, Inc. (1) High Yield Debt 15,150 15,150
- -----------------------------------------------------------------------------------------------------
Love Funding Corporation Series D Preferred Stock (26,000 shares) 359 213
- -----------------------------------------------------------------------------------------------------
May Investments Loan 47 --
- -----------------------------------------------------------------------------------------------------
Meigher Communications, L.P. Loan 2,923 2,923
- -----------------------------------------------------------------------------------------------------
Mid Atlantic Telecom Plus, LLC Loan 10,604 10,604
- -----------------------------------------------------------------------------------------------------
Midview Associates, L.P. Debt Securities 165 165
Options -- --
- -----------------------------------------------------------------------------------------------------
Mihadas Loan 286 286
- -----------------------------------------------------------------------------------------------------
Mill-It Striping, Inc. Common Stock (18 shares) 250 --
- -----------------------------------------------------------------------------------------------------
Monitoring Solutions, Inc. Loans 17 17
Debt Securities 1,823 219
Common Stock (33,333 shares) -- --
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Morton Industrial Group (1) Common Stock (5,835 shares) 241 82
- -----------------------------------------------------------------------------------------------------
New York Donut Corporation Loan 49 49
- -----------------------------------------------------------------------------------------------------
Nobel Learning Communities, Debt Securities 9,437 9,437
Inc. (1) Series D Convertible Preferred Stock 2,000 2,000
(265,957 shares)
Warrants 575 575
- -----------------------------------------------------------------------------------------------------
Norman's Yogurt, Inc. Loan 3 3
- -----------------------------------------------------------------------------------------------------
Northeast Broadcasting Group, Debt Securities 406 406
L.P.
- -----------------------------------------------------------------------------------------------------
Nursefinders, Inc. Debt Securities 10,853 10,853
Warrants 900 900
- -----------------------------------------------------------------------------------------------------
Old Mill Holdings, Inc. Debt Securities 589 140
Warrants 77 --
- -----------------------------------------------------------------------------------------------------
PAL Liberty, Inc. Loan 223 223
- -----------------------------------------------------------------------------------------------------
David Peters Loan 162 55
- -----------------------------------------------------------------------------------------------------
PIATL Holdings, Inc. Loan 31 31
Preferred Stock (276 shares) 160 222
Common Stock (24 shares) -- --
- -----------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-7
<PAGE> 80

<TABLE>
<CAPTION>
PORTFOLIO COMPANY MARCH 31, 1999
(IN THOUSANDS, EXCEPT NUMBER -------------------
OF SHARES) INVESTMENT(2) COST VALUE
- --------------------------------- --------------------------------------------- -------- --------
(UNAUDITED)
<S> <C> <C> <C>
Pico Products, Inc. (1) Debt Securities $ 4,091 $ 4,091
Common Stock (208,000 shares) 59 21
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Precision Industries Co. Debt Securities 9,711 9,711
Common Stock (132,507 shares) 1,050 2,561
- -----------------------------------------------------------------------------------------------------
Progressive International Debt Securities 3,933 3,933
Corporation Preferred Stock (500 shares) 500 500
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Quality Software Products Common Stock (94,479 shares) 901 806
Holdings, PLC (1)
- -----------------------------------------------------------------------------------------------------
Radio One, Inc. Common Stock (14 shares) -- 5,000
- -----------------------------------------------------------------------------------------------------
R.L. Singletary Loan 96 96
- -----------------------------------------------------------------------------------------------------
Schwinn/GT Debt Securities 9,690 9,690
Warrants 395 395
- -----------------------------------------------------------------------------------------------------
Seasonal Expressions, Inc. Series A Preferred Stock (1,000 shares) 993 493
- -----------------------------------------------------------------------------------------------------
Spa Lending Corporation Preferred Stock (28,625 shares) 315 225
Common Stock (6,208 shares) 24 --
- -----------------------------------------------------------------------------------------------------
SunStates Refrigerated Services, Loans 1,830 341
Inc.
Debt Securities 2,445 676
- -----------------------------------------------------------------------------------------------------
Sydran Food Services II, L.P. Debt Securities 11,884 11,884
Options -- --
- -----------------------------------------------------------------------------------------------------
Total Foam, Inc. Debt Securities 1,553 106
Common Stock (910 shares) 57 --
- -----------------------------------------------------------------------------------------------------
Tubbs Snowshoe Company, LLC Debt Securities 3,946 3,946
Warrants 54 54
Common Units (2,325 units) 500 500
- -----------------------------------------------------------------------------------------------------
Unitel, Inc. Debt Securities 3,607 3,607
Warrants 360 360
- -----------------------------------------------------------------------------------------------------
Vianova Resins GmbH Debt Securities 1,632 1,632
Warrants -- --
- -----------------------------------------------------------------------------------------------------
Vidon, Inc. Loan 258 258
- -----------------------------------------------------------------------------------------------------
William R. Dye Loan 264 264
- -----------------------------------------------------------------------------------------------------
Williams Brothers Lumber Company Warrants 24 322
- -----------------------------------------------------------------------------------------------------
Wilton Industries, Inc. Loan 12,000 12,000
- -----------------------------------------------------------------------------------------------------
WYCB Acquisition Corporation Loan 3,842 3,842
- -----------------------------------------------------------------------------------------------------
Wyo-Tech Acquisition Debt Securities 15,099 15,094
Corporation Common Stock (99 shares) 100 100
Preferred Stock (100 shares) 3,700 3,700
- -----------------------------------------------------------------------------------------------------
Total mezzanine loans and debt securities and equity
interests in portfolio companies (97 investments) $396,789 $407,489
- -----------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-8
<PAGE> 81

<TABLE>
<CAPTION>
MARCH 31, 1999
INTEREST NUMBER OF -------------------
RATE RANGES INVESTMENTS COST VALUE
---------------- ----------- -------- --------
(UNAUDITED)
<S> <C> <C> <C> <C>
COMMERCIAL MORTGAGE LOANS
Up to 6.99% 3 $ 1,326 $ 1,326
7.00%- 8.99% 33 86,087 86,087
9.00%- 10.99% 88 71,571 71,883
11.00%-12.99% 20 39,066 39,066
13.00%-14.99% 4 12,378 12,378
15.00% and above 1 125 125
- -------------------------------------------------------------------------------------------------
Total commercial mortgage loans 149 $210,553 $210,865
- -------------------------------------------------------------------------------------------------
COMMERCIAL MORTGAGE-BACKED SECURITIES
Subordinated CMBS 3 $116,344 $116,344
- -------------------------------------------------------------------------------------------------
Residual CMBS 2 75,007 75,007
- -------------------------------------------------------------------------------------------------
Residual securitization spread 1 10,932 9,432
- -------------------------------------------------------------------------------------------------
Total commercial mortgage-backed securities 6 $202,283 $200,783
- -------------------------------------------------------------------------------------------------
SMALL BUSINESS ADMINISTRATION 7(a) LOANS
Up to 6.99% 2 $ 71 $ 71
7.00%- 8.99% 8 135 58
9.00%- 10.99% 374 56,624 56,672
11.00%-12.99% 30 1,879 1,298
13.00%-14.99% 4 276 191
15.00% and above -- -- --
- -------------------------------------------------------------------------------------------------
Total Small Business Administration 7(a) loans 418 $ 58,985 $ 58,290
- -------------------------------------------------------------------------------------------------
Other portfolio assets 8 $ 8,639 $ 8,411
- -------------------------------------------------------------------------------------------------
Total portfolio 678 $877,249 $885,838
- -------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-9
<PAGE> 82

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INVESTMENTS

Acme Paging, L.P. Debt Securities $ 6,273 $ 6,273
Partnership Interest 1,456 2,600
- -------------------------------------------------------------------------------------------------------
American Barbecue & Grill, Loans 1,475 1,475
Inc. Debt Securities 2,084 2,084
Warrants 125 125
- -------------------------------------------------------------------------------------------------------
AMF Bowling, Inc. (1) High Yield Debt 5,086 5,086
- -------------------------------------------------------------------------------------------------------
Arnold Moving Co., Inc. Loans 570 570
- -------------------------------------------------------------------------------------------------------
ASW Holding Corporation Warrants 25 25
- -------------------------------------------------------------------------------------------------------
Au Bon Pain Co., Inc. (1) Debt Securities 7,427 7,427
Warrants 227 8
- -------------------------------------------------------------------------------------------------------
Avborne, Inc. Debt Securities 12,510 12,510
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Brazos Sportswear, Inc. (1) Common Stock (342,938 shares) 330 --
- -------------------------------------------------------------------------------------------------------
Candlewood Hotel Company (1) Preferred Stock (3,250 shares) 3,250 3,250
- -------------------------------------------------------------------------------------------------------
Celebrities, Inc. Debt Securities 339 339
Warrants 12 12
- -------------------------------------------------------------------------------------------------------
CeraTech Holdings Corporation Debt Securities 1,991 50
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Cherry Tree Toys, Inc. Debt Securities 1,557 1,557
Common Stock (220 shares) 1 --
- -------------------------------------------------------------------------------------------------------
Convenience Corporation of Debt Securities 8,391 2,774
America Series A Preferred Stock (31,521 shares) 334 --
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Cooper Natural Resources, Debt Securities 3,450 3,450
Inc.
Warrants -- 1,138
- -------------------------------------------------------------------------------------------------------
CorrFlex Graphics, LLC Loan 5,860 5,860
- -------------------------------------------------------------------------------------------------------
Cosmetic Manufacturing Debt Securities 2,948 2,948
Resources, LLC Options -- --
- -------------------------------------------------------------------------------------------------------
Coverall North America Loan 8,915 8,915
- -------------------------------------------------------------------------------------------------------
Csabai Canning Factory Rt. Hungarian Quotas (9.2%) 700 700
- -------------------------------------------------------------------------------------------------------
DEH Printed Circuits, Inc. Warrants 250 250
- -------------------------------------------------------------------------------------------------------
DeVlieg-Bullard, Inc. (1) Warrants 350 133
- -------------------------------------------------------------------------------------------------------
Directory Investment Common Stock (470 shares) -- 148
Corporation
- -------------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-10
<PAGE> 83

<TABLE>
<CAPTION>
PORTFOLIO COMPANY DECEMBER 31, 1998
(IN THOUSANDS, EXCEPT NUMBER -------------------
OF SHARES) INVESTMENT(2) COST VALUE
- ----------------------------- --------------------------------------------------- -------- --------
<S> <C> <C> <C>
Directory Lending Corporation Series A Common Stock (1,031 shares) $ -- $ --
Series B Common Stock (188 shares) 235 161
Series C Common Stock (292 shares) 656 449
Series A Preferred Stock (214 shares) 307 210
Series B Preferred Stock (175 shares) 931 638
Series C Preferred Stock (58 shares) 58 40
- -------------------------------------------------------------------------------------------------------
Drilltec Patents & Loan 10,020 10,020
Technologies Company, Inc.
- -------------------------------------------------------------------------------------------------------
ECM Enterprises Loan 31 4
- -------------------------------------------------------------------------------------------------------
EDM Consulting, LLC Loans 30 30
Debt Securities 1,875 680
Common Stock (100 shares) 250 --
- -------------------------------------------------------------------------------------------------------
El Dorado Communications, Loans 306 306
Inc.
- -------------------------------------------------------------------------------------------------------
Enterprise Software, Inc. (1) Debt Securities 14,880 14,880
Common Stock (147,975 shares) 1,176 683
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Eparfin S.A. Loan 29 29
- -------------------------------------------------------------------------------------------------------
Esquire Communications Ltd. Warrants 6 --
(1)
- -------------------------------------------------------------------------------------------------------
Everything Yogurt Loan 34 34
- -------------------------------------------------------------------------------------------------------
Ex Terra Credit Recovery, Series A Preferred Stock (500 shares) 497 497
Inc. Common Stock (2,500 shares) 3 3
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Fairchild Industrial Products Debt Securities 5,702 5,702
Company Warrants 280 3,629
- -------------------------------------------------------------------------------------------------------
FHM Distributions, Inc. Loans 200 200
- -------------------------------------------------------------------------------------------------------
Galaxy American Debt Securities 30,703 30,703
Communications, LLC Warrants -- --
- -------------------------------------------------------------------------------------------------------
Gibson Guitar Corporation Debt Securities 15,080 15,080
Warrants 525 1,000
- -------------------------------------------------------------------------------------------------------
Ginsey Industries, Inc. Loans 5,000 5,000
Convertible Debentures 500 500
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Golden Eagle/Satellite Loans 1,390 1,390
Archery, LLC Convertible Debentures 2,248 2,242
- -------------------------------------------------------------------------------------------------------
Grant Broadcasting System II Warrants 139 3,600
- -------------------------------------------------------------------------------------------------------
Grant Television, Inc. Debt Securities 9,154 9,154
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Han Hie Loan 510 510
- -------------------------------------------------------------------------------------------------------
H.B.N. Communications, Inc. Loan 233 233
- -------------------------------------------------------------------------------------------------------
Hotelevision, Inc. Preferred Stock (1,000,000 shares) 1,000 1,000
- -------------------------------------------------------------------------------------------------------
In the Dough, Inc. Loan 2 2
- -------------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-11
<PAGE> 84

<TABLE>
<CAPTION>
PORTFOLIO COMPANY DECEMBER 31, 1998
(IN THOUSANDS, EXCEPT NUMBER -------------------
OF SHARES) INVESTMENT(2) COST VALUE
- ----------------------------- --------------------------------------------------- -------- --------
<S> <C> <C> <C>
Jack Henry & Associates, Inc. Common Stock (90,438 shares) $ 26 $ 4,193
(1)
- -------------------------------------------------------------------------------------------------------
Jeff & Chris Mufflers, Inc. Loan 93 93
- -------------------------------------------------------------------------------------------------------
JRI Industries, Inc. Debt Securities 2,111 2,111
Warrants 74 74
- -------------------------------------------------------------------------------------------------------
Julius Koch USA, Inc. Debt Securities 4,692 4,692
Warrants 324 2,100
- -------------------------------------------------------------------------------------------------------
Kirker Enterprises, Inc. Loans 3,739 3,739
Debt Securities 2,609 2,609
Warrants 348 3,500
Equity Interest 3 3
- -------------------------------------------------------------------------------------------------------
Kirkland's, Inc. Debt Securities 6,283 6,283
Warrants 96 2,850
- -------------------------------------------------------------------------------------------------------
Kyrus Corporation Debt Securities 7,601 7,601
Warrants 348 348
- -------------------------------------------------------------------------------------------------------
KZSF Broadcasting, Inc. Loans 884 884
- -------------------------------------------------------------------------------------------------------
Liberty-Pittsburgh Systems, Debt Securities 3,403 3,403
Inc. Common Stock (64,535 shares) 142 142
- -------------------------------------------------------------------------------------------------------
Lingcomm, Inc. Loan 207 207
- -------------------------------------------------------------------------------------------------------
Liqui-Dri Foods, Inc. Loans 10,291 10,291
- -------------------------------------------------------------------------------------------------------
The Loewen Group, Inc. (1) High Yield Debt 15,002 15,002
- -------------------------------------------------------------------------------------------------------
Love Funding Corporation Series D Preferred Stock (26,000 shares) 359 213
- -------------------------------------------------------------------------------------------------------
May Investments Loan 47 --
- -------------------------------------------------------------------------------------------------------
Meigher Communications, L.P. Loan 2,918 2,918
- -------------------------------------------------------------------------------------------------------
Mid Atlantic Telecom Plus, Loan 10,434 10,434
LLC
- -------------------------------------------------------------------------------------------------------
Midview Associates, L.P. Debt Securities 197 197
Options -- --
- -------------------------------------------------------------------------------------------------------
Mihadas Loan 287 287
- -------------------------------------------------------------------------------------------------------
Mill-It Striping, Inc. Common Stock (18 shares) 250 --
- -------------------------------------------------------------------------------------------------------
Monitoring Solutions, Inc. Loans 17 17
Debt Securities 1,823 219
Common Stock (33,333 shares) -- --
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Morton Industrial Group (1) Common Stock (5,835 shares) 241 82
- -------------------------------------------------------------------------------------------------------
New York Donut Corporation Loan 61 61
- -------------------------------------------------------------------------------------------------------
Nobel Learning Communities, Debt Securities 9,419 9,419
Inc. (1) Series D Convertible Preferred Stock 2,000 2,000
(265,957 shares)
Warrants 575 575
- -------------------------------------------------------------------------------------------------------
Norman's Yogurt, Inc. Loan 8 8
- -------------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-12
<PAGE> 85

<TABLE>
<CAPTION>
PORTFOLIO COMPANY DECEMBER 31, 1998
(IN THOUSANDS, EXCEPT NUMBER -------------------
OF SHARES) INVESTMENT(2) COST VALUE
- ----------------------------- --------------------------------------------------- -------- --------
<S> <C> <C> <C>
Northeast Broadcasting Group, Debt Securities $ 415 $ 415
L.P.
- -------------------------------------------------------------------------------------------------------
Nursefinders, Inc. Debt Securities 10,841 10,841
Warrants 900 900
- -------------------------------------------------------------------------------------------------------
Old Mill Holdings, Inc. Debt Securities 589 140
Warrants 77 --
- -------------------------------------------------------------------------------------------------------
PAL Liberty, Inc. Loan 229 229
- -------------------------------------------------------------------------------------------------------
David Peters Loan 164 55
- -------------------------------------------------------------------------------------------------------
PIATL Holdings, Inc. Loan 31 31
Preferred Stock (276 shares) 160 222
Common Stock (24 shares) -- --
- -------------------------------------------------------------------------------------------------------
Pico Products, Inc. (1) Debt Securities 4,091 4,091
Common Stock (208,000 shares) 59 33
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Precision Industries Co. Debt Securities 9,580 9,580
Common Stock (132,507 shares) 1,050 1,616
- -------------------------------------------------------------------------------------------------------
Progressive International Debt Securities 3,680 3,680
Corporation Preferred Stock (500 shares) 500 500
Warrants -- --
- -------------------------------------------------------------------------------------------------------
Quality Software Products Common Stock (94,479 shares) 901 557
Holdings, PLC (1)
- -------------------------------------------------------------------------------------------------------
Radio One of Atlanta, Inc. Loans 2,000 2,000
Debt Securities 9,972 9,972
Common Stock (1,430 shares) -- 3,000
- -------------------------------------------------------------------------------------------------------
Randhawa Brothers Loan 117 117
Enterprises, Inc.
- -------------------------------------------------------------------------------------------------------
R.L. Singletary Loan 98 98
- -------------------------------------------------------------------------------------------------------
Schwinn/GT Debt Securities 9,605 9,605
Warrants 395 395
- -------------------------------------------------------------------------------------------------------
Seasonal Expressions, Inc. Series A Preferred Stock (1,000 shares) 993 993
- -------------------------------------------------------------------------------------------------------
Spa Lending Corporation Preferred Stock (28,625 shares) 399 306
Common Stock (6,208 shares) 24 --
- -------------------------------------------------------------------------------------------------------
SunStates Refrigerated Loans 1,830 341
Services, Inc. Debt Securities 2,445 676
- -------------------------------------------------------------------------------------------------------
Sydran Food Services II, L.P. Debt Securities 11,881 11,881
Options -- --
- -------------------------------------------------------------------------------------------------------
Total Foam, Inc. Debt Securities 1,562 106
Common Stock (910 shares) 57 --
- -------------------------------------------------------------------------------------------------------
Unitel, Inc. Debt Securities 3,579 3,579
Warrants 360 360
- -------------------------------------------------------------------------------------------------------
Vianova Resins GmbH Debt Securities 1,812 1,812
Warrants -- --
- -------------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-13
<PAGE> 86

<TABLE>
<CAPTION>
DECEMBER 31, 1998
INTEREST NUMBER OF -------------------
RATE RANGES INVESTMENTS COST VALUE
---------------- ----------- -------- --------
<S> <C> <C> <C> <C>
COMMERCIAL MORTGAGE LOANS
Up to 6.99% 3 $ 1,327 $ 1,327
7.00%- 8.99% 43 104,872 104,872
9.00%-10.99% 102 69,635 70,076
11.00%-12.99% 31 44,424 44,424
13.00%-14.99% 4 12,362 12,362
15.00% and above 1 125 125
- ------------------------------------------------------------------------------------------------
Total commercial mortgage loans 184 $232,745 $233,186
- ------------------------------------------------------------------------------------------------
COMMERCIAL MORTGAGE-BACKED SECURITIES
Subordinated CMBS 1 $ 32,221 $ 32,221
- ------------------------------------------------------------------------------------------------
Residual CMBS 1 70,771 70,771
- ------------------------------------------------------------------------------------------------
Residual securitization spread 1 12,182 10,682
- ------------------------------------------------------------------------------------------------
Total commercial mortgage-backed securities 3 $115,174 $113,674
- ------------------------------------------------------------------------------------------------
SMALL BUSINESS ADMINISTRATION 7(A) LOANS
Up to 6.99% 12 $ 160 $ 115
7.00%- 8.99% 12 134 57
9.00%-10.99% 364 51,925 51,343
11.00%-12.99% 53 5,148 4,592
13.00%-14.99% 5 284 178
15.00% and above -- -- --
- ------------------------------------------------------------------------------------------------
Total Small Business Administration 7(a) loans 446 $ 57,651 $ 56,285
- ------------------------------------------------------------------------------------------------
Other portfolio assets 6 $ 8,331 $ 8,575
- ------------------------------------------------------------------------------------------------
Total portfolio at value 733 $796,389 $800,274
- ------------------------------------------------------------------------------------------------
</TABLE>

(1) Public company.
(2) Common stock, preferred stock, warrants and equity interests are generally
non-income producing and restricted.

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

F-14
<PAGE> 87

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. MERGER

On December 31, 1997, Allied Capital Corporation ("Allied I"), Allied
Capital Corporation II ("Allied II"), Allied Capital Commercial Corporation
("Allied Commercial"), and Allied Capital Advisers ("Advisers"), merged with and
into Allied Capital Lending Corporation ("Allied Lending") (each a "Predecessor
Company" and collectively the "Predecessor Companies") pursuant to an Agreement
and Plan of Merger, dated as of August 14, 1997, as amended and restated as of
September 19, 1997 in a stock-for-stock exchange (the "Merger"). Immediately
following the Merger, Allied Lending changed its name to Allied Capital
Corporation ("ACC" or the "Company").

The Merger was treated as a tax-free reorganization under Section 368
(a)(1)(A) of the Internal Revenue Code of 1986, as amended (the "Code"). For
federal income tax purposes, the Predecessor Companies carried forward the
historical cost basis of their assets and liabilities to the surviving entity
(ACC). For financial reporting purposes, the Predecessor Companies also carried
forward the historical cost basis of their respective assets and liabilities at
the time the Merger was effected. The consolidated financial statements reflect
the operations of ACC with the years ended December 31, 1997 and 1996 restated
as if the Predecessor Companies had merged as of the beginning of the earliest
period presented.

Prior to the Merger, Allied I owned approximately 16 percent of Allied
Lending's total shares outstanding. These shares were distributed to the Allied
I shareholders in a dividend immediately prior to the Merger at a rate of
0.107448 shares of Allied Lending for each share of Allied I held on the record
date. For financial reporting purposes, Allied I's ownership of Allied Lending
has been eliminated for all periods presented.

NOTE 2. ORGANIZATION

Allied Capital Corporation, a Maryland corporation, is a closed-end
management investment company that has elected to be regulated as a business
development company ("BDC") under the Investment Company Act of 1940 ("1940
Act"). The Company has two wholly owned subsidiaries that have also elected to
be regulated as BDCs. Allied Investment Corporation is licensed under the Small
Business Investment Act of 1958 as a Small Business Investment Company ("SBIC").
Allied Investment Corporation is the result of the merger of the Company's two
wholly owned SBIC subsidiaries in July 1998 whereby Allied Investment
Corporation merged with and into Allied Capital Financial Corporation ("Allied
Financial"). Allied Financial then changed its name to Allied Investment
Corporation ("Allied Investment"). Allied Capital SBLC Corporation ("Allied
SBLC") is licensed by the Small Business Administration ("SBA") as a Small
Business Lending Company and is a participant in the SBA Section 7(a) Guaranteed
Loan Program. In addition, the Company has also established a real estate
investment trust subsidiary, Allied Capital REIT, Inc. ("Allied REIT"). The
Company also has several single-member limited liability companies established
primarily to hold real estate properties.

Allied Capital Corporation and its subsidiaries, collectively, are
hereinafter referred to as the "Company" or "ACC."

The investment objective of the Company is to achieve current income and
capital gains. In order to achieve this objective, the Company invests primarily
in private, growing businesses in a variety of industries and in diverse
geographic locations (primarily in the United States).

F-15
<PAGE> 88
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

The consolidated financial statements for the periods presented have been
restated to include the accounts of the Predecessor Companies for all periods
presented. Transaction fees and expenses related to the Merger were expensed in
the fourth quarter of 1997. The consolidated financial statements include the
accounts of the Company or its wholly owned or majority owned subsidiaries. All
intercompany accounts and transactions have been eliminated in consolidation.
Certain reclassifications have been made to the 1998, 1997 and 1996 balances to
conform with the 1999 financial statement presentation.

VALUATION OF PORTFOLIO INVESTMENTS

Portfolio assets are carried at fair value as determined by the Board of
Directors under the Company's valuation policy.

LOAN AND DEBT SECURITIES

The values of loans and debt securities are considered to be amounts which
could be realized in the normal course of business which, generally, anticipates
the Company holding the loan to maturity and realizing the face value of the
loan. For loans and debt securities, value normally corresponds to cost unless
the borrower's condition or external factors lead to a determination of value at
a lower amount.

Interest income is recorded on the accrual basis to the extent that such
amounts are expected to be collected. Loan origination fees, original issue
discount, and market discount are amortized into interest income using the
effective interest method.

EQUITY SECURITIES

Equity interests in portfolio companies for which there is no public market
are valued based on various factors including a history of positive cash flow
from operations, the market value of comparable publicly traded companies and
other pertinent factors, such as recent offers to purchase a portfolio company's
securities or other liquidation events. The determined values are generally
discounted to account for liquidity issues and minority control positions.

The Company's equity interests in public companies that carry certain
restrictions on sale are typically valued at a discount from the public market
value of the security at the balance sheet date. Restricted and unrestricted
publicly traded stocks may also be valued at a discount due to the investment
size or market liquidity concerns.

COMMERCIAL MORTGAGE-BACKED SECURITIES

Commercial mortgage-backed securities consist of subordinated commercial
mortgage-backed securities ("Subordinated CMBS"), residual interest in mortgage
securitization ("Residual CMBS") and residual securitization spread.

SUBORDINATED CMBS

The Subordinated CMBS is carried at fair value. The Company recognizes
income from Subordinated CMBS using the effective interest method, using the
anticipated yield over the

F-16
<PAGE> 89
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
projected life of the investment. Changes in estimated yields are due to
revisions in estimates of future credit losses, actual losses incurred and
actual prepayment speeds. Changes in estimated yield are currently recognized as
an adjustment to the estimated yield over the remaining life of the Subordinated
CMBS. The Company recognizes unrealized depreciation on its Subordinated CMBS
whenever it determines that the value of its Subordinated CMBS is less than the
carrying amount.

RESIDUAL CMBS

The Company values its residual interest in securitization and recognizes
income using the same accounting policies used for the Subordinated CMBS.

RESIDUAL SECURITIZATION SPREAD (INTEREST-ONLY STRIP)

The residual securitization spread is carried at fair value based on the
amortized cost of the residual securitization spread and the estimated future
cash flows. The Company recognizes income using the effective interest method.
At each reporting date, the effective yield is recalculated and used to
recognize income until the next reporting date.

NET REALIZED AND UNREALIZED GAINS

Realized gains or losses are measured by the difference between the net
proceeds from the sale and the cost basis of the investment without regard to
unrealized gains or losses previously recognized, and include investments
charged off during the year, net of recoveries. Unrealized gains or losses
reflect the change in portfolio investment values during the reporting period.

DEFERRED FINANCING COSTS

Financing costs are based on actual costs incurred in obtaining financing
and are deferred and amortized as part of interest expense over the term of the
related debt instrument.

DERIVATIVE FINANCIAL INSTRUMENTS

The Company may use derivative financial instruments to reduce interest
rate risk. The Company has established policies and procedures for risk
assessment and the approval, reporting and monitoring of derivative financial
instrument activities. The Company does not hold or issue derivative financial
instruments for trading purposes.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents include cash in banks and all highly liquid
investments with original maturities of three months or less.

DISTRIBUTIONS TO SHAREHOLDERS

Distributions to shareholders are recorded on the record date.

FEDERAL AND STATE INCOME TAXES

With the exception of Advisers, the Predecessor Companies qualified as
regulated investment companies ("RIC") or a real estate investment trust
("REIT"); however, Advisers was a corporation

F-17
<PAGE> 90
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
subject to federal and state income taxes. Income tax expense reported on the
consolidated statement of operations relates to the operations of Advisers for
all periods presented.

The Company and its wholly owned subsidiaries intend to comply with the
requirements of the Code that are applicable to RICs and REITs. The Company and
its wholly owned subsidiaries intend to distribute annually all of their taxable
income to shareholders; therefore, the Company has made no provision for income
taxes.

PER SHARE INFORMATION

Basic earnings per share is calculated using the weighted average number of
shares outstanding for the period presented. Diluted earnings per share reflects
the potential dilution that could occur if options to issue common stock were
exercised into common stock. Earnings per share is computed after subtracting
dividends on Preferred Shares.

USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from these estimates.

NOTE 4. PORTFOLIO

The Company's lending operations are conducted in three primary areas:
mezzanine finance, commercial real estate finance, and SBA Section 7(a)
guaranteed lending.

MEZZANINE FINANCE

Mezzanine investments are generally structured as loans that carry a
relatively high fixed rate of interest, which may be combined with equity
features, such as conversion privileges, warrants or options to purchase a
portion of the portfolio company's equity at a nominal price. Such an investment
would typically have a maturity of five to ten years, with interest-only
payments in the early years and payments of both principal and interest in the
later years, although loan maturities and principal amortization schedules vary.

Equity investments consist primarily of securities issued by privately
owned companies and may be subject to restrictions on their resale or otherwise
illiquid. Equity securities generally do not produce a current return, but are
held for investment appreciation and ultimate gain on sale.

At March 31, 1999, December 31, 1998 and 1997, approximately 98 percent of
the Company's mezzanine loan portfolio was composed of fixed interest rate
loans. The weighted average yield (at value) on the mezzanine portfolio at March
31, 1999, December 31, 1998 and 1997 was 14.0 percent, 14.6 percent, and 12.6
percent, respectively. At March 31, 1999, December 31, 1998 and 1997, mezzanine
loans and debt securities with a cost basis of $24,922,000, $20,977,000 and
$13,661,000, respectively, were not accruing interest.

F-18
<PAGE> 91
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 4. PORTFOLIO, CONTINUED

The geographic and industry composition of the mezzanine portfolio at March
31, 1999, December 31, 1998 and 1997 was as follows:

<TABLE>
<CAPTION>
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
GEOGRAPHIC REGION
Mid-Atlantic................................................ 26% 28% 29%
Midwest..................................................... 25 27 17
Southeast................................................... 22 23 27
West........................................................ 15 11 13
International............................................... 7 7 6
Northeast................................................... 5 4 8
--- --- ---
Total............................................. 100% 100% 100%
=== === ===

INDUSTRY
Consumer Products........................................... 22% 25% 25%
Telecommunications.......................................... 15 14 7
Business Services........................................... 13 11 7
Retail...................................................... 8 9 14
Industrial Products......................................... 8 8 9
Broadcasting................................................ 6 9 23
Other....................................................... 28 24 15
--- --- ---
Total............................................. 100% 100% 100%
=== === ===
</TABLE>

COMMERCIAL REAL ESTATE FINANCE

The commercial mortgage loan portfolio contains loans that were originated
by the Company or were purchased from the Resolution Trust Corporation, the
Federal Deposit Insurance Corporation and other third party sellers including
life insurance companies and banks.

At March 31, 1999, December 31, 1998 and 1997, approximately 60 percent and
40 percent, 68 percent and 32 percent, and 73 percent and 27 percent of the
Company's commercial mortgage loan portfolio was composed of fixed and
adjustable interest rate loans, respectively. The weighted average yield (at
value) on the real estate portfolio as of March 31, 1999, December 31, 1998 and
1997 equaled 10.4 percent, 10.4 percent and 11.4 percent, respectively. As of
March 31, 1999, December 31, 1998 and 1997, loans with a cost basis of
$4,804,000, $5,443,000 and $11,987,000, respectively, were not accruing
interest.

F-19
<PAGE> 92
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 4. PORTFOLIO, CONTINUED

The geographic composition and the property types securing the commercial
mortgage loan portfolio at March 31, 1999, December 31, 1998 and 1997 were as
follows:

<TABLE>
<CAPTION>
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
GEOGRAPHIC REGION
Mid-Atlantic................................................ 37% 36% 38%
Southeast................................................... 29 23 14
West........................................................ 20 22 18
Midwest..................................................... 9 13 18
Northeast................................................... 5 6 12
--- --- ---
Total............................................. 100% 100% 100%
=== === ===

PROPERTY TYPE
Hospitality................................................. 46% 42% 34%
Office...................................................... 21 29 32
Retail...................................................... 14 14 17
Recreation.................................................. 12 5 4
Other....................................................... 7 10 13
--- --- ---
Total............................................. 100% 100% 100%
=== === ===
</TABLE>

COMMERCIAL MORTGAGE-BACKED SECURITIES

In December 1998, the Company purchased $67 million of Subordinated
Commercial Mortgage Backed Securities ("Subordinated CMBS") for $32 million. In
the first quarter of 1999, the Company purchased for a price of $88.0 million,
Subordinated CMBS with a face value of $177.9 million. The bonds owned by the
Company of non-investment grade and unrated tranches are junior in priority for
payment of principal to the more senior tranches of the related commercial
securitization. Cash flow from the underlying mortgages generally is allocated
first to the senior tranches, with the most senior tranches having a priority
right to the cash flow. Then, any remaining cash flow is allocated, generally,
among the other tranches in order of their relative seniority. To the extent
there are defaults and unrecoverable losses on the underlying mortgages
resulting in reduced cash flows, the subordinate tranche will bear this loss
first.

As of March 31, 1999 and December 31, 1998, the estimated yield to maturity
on the Subordinated CMBS was approximately 14.6 percent and 15.0 percent,
respectively. The Company's estimated returns on its Subordinated CMBS are based
upon a number of assumptions that are subject to certain business and economic
uncertainties and contingencies. Examples include the timing and magnitude of
credit losses on the mortgage loans underlying the Subordinated CMBS that are a
result of the general condition of the real estate market (including competition
for tenants and their related credit quality) and changes in market rental
rates. As these uncertainties and contingencies are difficult to predict and are
subject to future events which may alter these assumptions, no assurance can be
given that the anticipated yields to maturity, will be achieved.

On January 30, 1998, the Company in conjunction with Business Mortgage
Investors, Inc. ("BMI"), a private REIT managed by the Company, completed a $310
million asset securitization, whereby bonds totaling $239 million were sold in
three classes rated "AAA", "AA" and "A" by

F-20
<PAGE> 93
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 4. PORTFOLIO, CONTINUED
Standard & Poor's Rating Services and Fitch IBCA, Inc. in a private placement.
The three bond classes sold had an aggregate weighted average interest rate of
approximately 6.38 percent.

To effect the securitization, the Company and BMI sold a pool of 97
commercial mortgage loans totaling $310 million to a special purpose, bankruptcy
remote entity which transferred the assets to a trust which issued the bonds.
The Company contributed approximately 95%, or $295 million, of the total assets
securitized, and received cash proceeds, net of costs of approximately $223
million. The Company retained a trust certificate for its residual interest (the
"Residual CMBS") in the loan pool sold, and will receive interest income from
this Residual CMBS as well as the net spread of the interest earned on the loans
sold less the interest paid on the bonds over the life of the bonds (the
"Residual Securitization Spread").

SBA SECTION 7(a) GUARANTEED LENDING

The Company, through its wholly owned subsidiary, Allied SBLC, participates
in the SBA's Section 7(a) Guaranteed Loan Program ("7(a) loans").

Pursuant to Section 7(a) of the Small Business Act of 1958, the SBA will
guarantee 80 percent of any qualified loan up to $100,000 regardless of
maturity, and 75 percent of any such loan over $100,000 regardless of maturity,
to a maximum guarantee of $750,000 for any one borrower. SBA regulations define
qualified small businesses generally as businesses with no more than $5 million
in annual sales or no more than 500 employees.

The Company charges interest on the 7(a) loans at a variable rate,
typically 1.75 percent to 2.75 percent above the prime rate, as published in The
Wall Street Journal or other financial newspaper, adjusted monthly. All loans
are payable in equal monthly installments of principal and interest from the
date on which the loan was made to its maturity. At March 31, 1999, December 31,
1998 and 1997, approximately 97 percent, 96 percent and 92 percent, respectively
of the Company's portfolio of 7(a) loans were variable interest rate loans.

As permitted by SBA regulations, the Company sells to investors, without
recourse, the guaranteed portion of its loans while retaining the right to
service 100 percent of such loans.

As of March 31, 1999, December 31, 1998 and 1997, 7(a) loans with a cost
basis of $8,729,000, $11,227,000 and $4,346,000, respectively, were not accruing
interest.

F-21
<PAGE> 94
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 4. PORTFOLIO, CONTINUED

The geographic and industry composition of the SBA 7(a) portfolio at March
31, 1999, December 31, 1998 and 1997 was as follows:

<TABLE>
<CAPTION>
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
GEOGRAPHIC REGION
Midwest..................................................... 38% 34% 36%
Mid-Atlantic................................................ 30 29 29
Southeast................................................... 15 16 18
West........................................................ 12 14 7
Northeast................................................... 5 7 10
--- --- ---
Total............................................. 100% 100% 100%
=== === ===

INDUSTRY
Retail...................................................... 42% 41% 37%
Hospitality................................................. 29 30 26
Consumer Products........................................... 6 6 7
Consumer Services........................................... 5 6 4
Business Services........................................... 4 4 6
Broadcasting................................................ 3 4 8
Other....................................................... 11 9 12
--- --- ---
Total............................................. 100% 100% 100%
=== === ===
</TABLE>

NOTE 5. DEBT

At March 31, 1999, December 31, 1998 and 1997, the Company had the
following credit facilities:

<TABLE>
<CAPTION>
1999 1998 1997
------------------- ------------------- -------------------
FACILITY AMOUNT FACILITY AMOUNT FACILITY AMOUNT
AMOUNT DRAWN AMOUNT DRAWN AMOUNT DRAWN
-------- -------- -------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Debentures and notes payable:
Master loan and security
agreement.............. $250,000 $ 56,392 $250,000 $ 6,000 $250,000 $ 23,116
Unsecured long-term notes
payable................ 180,000 180,000 180,000 180,000 -- --
SBA debentures........... 74,650 47,650 74,650 47,650 54,300 54,300
OPIC loan................ 5,700 5,700 5,700 5,700 20,000 8,700
Master repurchase
agreement.............. -- -- 250,000 -- 250,000 202,705
Senior note payable...... -- -- -- -- 20,000 20,000
-------- -------- -------- -------- -------- --------
Total debentures and
notes payable..... 510,350 289,742 760,350 239,350 594,300 308,821
======== ======== ======== ======== ======== ========
Revolving lines of credit..... 315,000 121,000 200,000 95,000 80,000 38,842
-------- -------- -------- -------- -------- --------
Total Debt.......... $825,350 $410,742 $960,350 $334,350 $674,300 $347,663
======== ======== ======== ======== ======== ========
</TABLE>

F-22
<PAGE> 95
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 5. DEBT, CONTINUED
MASTER LOAN AND SECURITY AGREEMENT

The Company, and BMI, established a facility to borrow up to $250,000,000,
of which $100,000,000 is committed, using commercial mortgage loans as
collateral under the agreement. The Company pledges commercial mortgage loans as
collateral for the facility such that the amount borrowed is approximately equal
to 80 percent to 90 percent of the value of the collateral pledged. The
agreement generally requires interest only payments with all principal due at
maturity. Principal may be repaid at any time without penalty. The agreement
bears interest at the one-month London Interbank Offer Rate ("LIBOR") plus 1.0
percent, or 5.9 percent, 6.6 percent and 6.7 percent, at March 31, 1999,
December 31, 1998 and 1997, respectively. Average debt outstanding, maximum
amount borrowed, and weighted average interest rate charged on this facility for
the three months ended March 31, 1999 and for the years ended December 31, 1998
and 1997 were $48,818,000, $21,932,000 and $17,899,000; $84,392,000, $56,000,000
and $23,116,000; and 6.1 percent, 6.5 percent and 6.7 percent; respectively. The
agreement matures on October 7, 1999.

UNSECURED LONG-TERM NOTES PAYABLE

In June 1998 the Company issued three classes of unsecured long-term notes
held by private institutional investors. The notes have terms of 5 or 7 years
with an aggregate principal balance of $180,000,000. The weighted average
interest rate on the notes is 7.2 percent and interest only is payable
semi-annually until maturity. The notes may be prepaid in whole or in part
together with an interest premium as stipulated in the note agreement.

SBA DEBENTURES

At March 31, 1999, December 31, 1998 and 1997, the Company had drawn
debentures totaling $47,650,000, $47,650,000 and $54,300,000, respectively,
payable to the SBA at interest rates ranging from 6.9 percent to 9.6 percent.
Scheduled maturity dates are as follows: 1999 -- $0; 2000 -- $17,300,000;
2001 -- $9,350,000; 2002 -- $0; 2003 -- $0; and $21,000,000 thereafter. The
debentures require semi-annual interest-only payments with all principal due
upon maturity. The SBA debentures are subject to prepayment penalties if paid
prior to maturity.

OVERSEAS PRIVATE INVESTMENT CORPORATION (OPIC) LOAN

The Company has a loan agreement with OPIC to provide financing for
international projects involving qualifying U.S. small businesses. Loans under
this agreement bear interest at the U.S. Treasury rate plus 0.5 percent for the
applicable period of the borrowing, or 6.6 percent, 6.6 percent and 6.8 percent
at March 31, 1999, December 31,1998 and 1997, respectively. In addition, OPIC is
entitled to receive from the Company a contingent fee at maturity of the loan
equal to 5 percent of the return generated by the OPIC-related investments in
excess of 7 percent. There are no required principal payments until the OPIC
loans mature in January 2006.

REVOLVING LINES OF CREDIT

In March 1999, the Company increased its unsecured revolving line of credit
to $315,000,000 from $200,000,000. The facility bears interest at LIBOR plus
1.25 percent, or 6.2 percent and 6.9 percent at March 31, 1999 and December 31,
1998, respectively, and requires a commitment fee

F-23
<PAGE> 96
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 5. DEBT, CONTINUED

equal to 0.25 percent of the committed amount. The new line expires in March
2001. The line of credit requires monthly payments of interest and all principal
is due upon its expiration.

The average debt outstanding on the revolving lines were $71,444,000,
$51,904,000 and $30,033,000 for the three months ended March 31, 1999 and for
the years ended December 31, 1998 and 1997, respectively. The maximum amount
borrowed under these facilities and the weighted average interest rate for the
three months ended March 31, 1999 and for the years ended December 31, 1998 and
1997 were $121,000,000, $105,000,000 and $45,759,000, and 6.6 percent, 6.8
percent and 8.1 percent, respectively.

NOTE 6. INCOME TAXES

For the years ended December 31, 1998, 1997 and 1996, the Company's
effective tax rate was 1.0 percent, 2.3 percent and 3.5 percent, respectively.
The Company incurred no income tax for the three months ended March 31, 1999.

For the year ended December 31, 1998, the Company incurred income tax
expense of $787,000 which resulted from the realization of a taxable net
built-in gain associated with property owned by Advisers prior to the Merger.

For the years ended December 31, 1997 and 1996, the Company's income
subject to federal and state taxes related to the income generated by the
pre-Merger operations of Advisers. The income generated by the other Predecessor
Companies is not subject to federal and state income taxes because these
companies qualified as regulated investment companies or a real estate
investment trust.

NOTE 7. PREFERRED STOCK

Allied Investment has outstanding a total of 60,000 shares of $100 par
value, 3 percent cumulative preferred stock and 10,000 shares of $100 par value,
4 percent redeemable cumulative preferred stock issued to the SBA pursuant to
Section 303(c) of the Small Business Investment Act of 1958, as amended. The 3
percent cumulative preferred stock does not have a required redemption date.
Allied Investment has the option to redeem in whole or in part the preferred
stock by paying the SBA the par value of such securities and any dividends
accumulated and unpaid to the date of redemption. The 4 percent redeemable
cumulative preferred stock has a required redemption date of June 4, 2005.

NOTE 8. SHAREHOLDERS' EQUITY

During the three months ended March 31, 1999, the Company sold 1,455,000
shares of its common stock through an underwriter for net proceeds of
$25,906,000, after costs of $1,375,000 which included a discount of 4.0 percent.
In addition, the Company sold 576,326 shares of its common stock to an
institutional investor. The net proceeds from the transaction were $9,881,000,
after costs of $428,000 which included a discount of 3.0 percent.

In 1998, the Company sold 3,565,000 shares of its common stock through an
underwriter for net proceeds of $56,776,000, after costs of $3,384,000 which
included a 5.0 percent fee paid to the underwriter. In 1998, the Company also
sold 801,959 shares of its common stock to an institutional investor in two
transactions. The net proceeds from the transactions were $12,899,000, after
costs of $677,000 which included a weighted average discount of 4.0 percent.

F-24
<PAGE> 97
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 8. SHAREHOLDERS' EQUITY, CONTINUED
In 1996, the Company completed two non-transferable subscription rights
offerings to common shareholders. The Company issued 1,433,414 shares of common
stock pursuant to these offerings raising net proceeds to the Company of
$17,147,000, after costs including a 2.5 percent fee paid to eligible
broker/dealers.

In 1996, the Company also sold 400,000 shares of its common stock through
an underwriter for net proceeds of $5,218,000.

The Company has a dividend reinvestment plan, whereby the Company may buy
shares of its common stock in the open market or issue new shares in order to
satisfy dividend reinvestment requests. If the Company issues new shares, the
issue price is equal to the average of the closing sales prices reported for the
Company's common stock for the five days on which trading in the shares takes
place immediately prior to the dividend payment date. For the three months ended
March 31, 1999 and for the years ended December 31, 1998, 1997 and 1996 the
Company issued 62,979, 241,482, 550,971 and 913,206 shares, respectively, at an
average price per share of $18.35, $20.35, $15.67 and $13.13, respectively.

F-25
<PAGE> 98
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 9. EARNINGS PER COMMON SHARE

<TABLE>
<CAPTION>
PER COMMON
INCOME SHARES SHARE AMOUNT
-------- ------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C>
FOR THE THREE MONTHS ENDED MARCH 31, 1999 (UNAUDITED)
Net increase in net assets resulting from operations... $18,580
Less: Preferred stock dividends (55)
-------
Income available to common shareholders................ $18,525
=======
BASIC EARNINGS PER COMMON SHARE........................ 56,799 $0.33
=====
Options outstanding to officers........................ 29
------
DILUTED EARNINGS PER COMMON SHARE...................... 56,828 $0.33
====== =====
FOR THE THREE MONTHS ENDED MARCH 31, 1998 (UNAUDITED)
Net increase in net assets resulting from operations... $32,065
Less: Preferred stock dividends........................ (55)
-------
Income available to common shareholders................ $32,010
=======
BASIC EARNINGS PER COMMON SHARE........................ 51,814 $0.62
=====
Options outstanding to officers........................ 294
------
DILUTED EARNINGS PER COMMON SHARE...................... 52,108 $0.61
====== =====
1998
Net increase in net assets resulting from operations... $78,078
Less: Preferred stock dividends........................ (230)
-------
Income available to common shareholders................ $77,848
=======
BASIC EARNINGS PER COMMON SHARE........................ 51,941 $1.50
=====
Options outstanding to officers........................ 33
------
DILUTED EARNINGS PER COMMON SHARE...................... 51,974 $1.50
====== =====
1997
Net increase in net assets resulting from operations... $61,304
Less: Preferred stock dividends........................ (220)
-------
Income available to common shareholders................ $61,084
=======
BASIC EARNINGS PER COMMON SHARE........................ 49,218 $1.24
=====
Options outstanding to officers........................ 33
------
DILUTED EARNINGS PER COMMON SHARE...................... 49,251 $1.24
====== =====
1996
Net increase in net assets resulting from operations... $54,947
Less: Preferred stock dividends........................ (220)
-------
Income available to common shareholders................ $54,727
=======
BASIC EARNINGS PER COMMON SHARE........................ 46,172 $1.19
=====
Options outstanding to officers........................ 561
------
DILUTED EARNINGS PER COMMON SHARE...................... 46,733 $1.17
====== =====
</TABLE>

F-26
<PAGE> 99
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 10. EMPLOYEE STOCK OWNERSHIP PLAN AND DEFERRED COMPENSATION PLAN

The Company has an employee stock ownership plan ("ESOP"). Pursuant to the
ESOP, the Company is obligated to contribute 5 percent of each eligible
participant's total cash compensation for the year to a plan account on the
participant's behalf, which vests over a two-year period. ESOP contributions are
used to purchase shares of the Company's common stock.

As of March 31, 1999, December 31, 1998 and 1997, the ESOP held 295,878
shares, 282,500 shares and 433,047 shares, respectively, of the Company's common
stock, the majority of which had been allocated to participants' accounts. The
plan is funded annually and the total ESOP contribution expense for the years
ended December 31, 1998, 1997, and 1996 was $489,000, $351,000 and $1,018,000,
respectively, net of forfeitures of $4,000, $0 and $36,000, respectively.

The Company also has a deferred compensation plan (the "DC Plan"). Eligible
participants in the DC Plan may elect to defer some of their compensation and
have such compensation credited to a participant account. All amounts credited
to a participant's account shall be credited solely for purposes of accounting
and computation and remain assets of the Company and subject to the claims of
the Company's general creditors. Amounts credited to participants under the DC
Plan are at all times 100 percent vested and non-forfeitable except for amounts
credited to participants' accounts related to the Formula Award (see Note 12). A
participant's account shall become distributable upon his or her separation from
service, retirement, disability, death, or at a future determined date. All DC
Plan accounts will be distributed in the event of a change of control of the
Company or in the event of the Company's insolvency. Amounts deferred by
participants under the DC Plan are funded to a trust, the trustee of which
administers the DC Plan on behalf of the Company.

NOTE 11. STOCK OPTION PLAN

In conjunction with the Merger, all stock option plans that existed for
Allied Lending and the Predecessor Companies before the Merger ("Old Plans")
were cancelled on December 31, 1997, and at a special meeting of shareholders on
November 26, 1997, the Company's shareholders approved a new stock option plan
("ACC Plan") for the Company to be effected post-Merger.

THE ACC PLAN

The purpose of the ACC Plan is to provide officers and non-officer
directors of the Company with additional incentives. Options may be granted from
time to time on up to 6,250,000 shares, which represents approximately 11
percent of the outstanding shares as of December 31, 1998.

Options are exercisable at a price equal to the fair market value of the
shares on the day the option is granted. Each option states the period or
periods of time within which the option may be exercised by the optionee, which
may not exceed ten years from the date the option is granted.

All rights to exercise options terminate 60 days after an optionee ceases
to be (i) a non-officer director, (ii) both an officer and a director, if such
optionee serves in both capacities, or (iii) an officer (if such officer is not
also a director) of the Company for any cause other than death or total and
permanent disability. If an optionee dies or becomes totally and permanently
disabled before expiration of the options without fully exercising them, he or
she or the executors or administrators or legatees or distributees of the estate
shall, as may be provided at the time of the grant, have the right, within one
year after the optionee's death or total and permanent disability, to exercise
the options in whole or in part before the expiration of their term. In the
event of a change of control of the Company, all outstanding options will become
fully vested and exercisable as of the change of

F-27
<PAGE> 100
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 11. STOCK OPTION PLAN, CONTINUED

control. For the three months ended March 31, 1999 and for the year ended
December 31, 1998, the Company's compensation committee granted a total of
30,000 options and 5,189,944 options, respectively, to officers of the Company
under the ACC Plan. The options awarded to officers were generally non-qualified
stock options that vest over a five-year period from the grant date. The stock
options have been granted at the market price on the date of grant with a
weighted average exercise price equal to $20.15 per share. At March 31, 1999,
options for 1,468,676 shares were vested. No options were exercised and 107,222
options were cancelled during the three months ended March 31, 1999. Options
were exercised for 10,408 shares, and options were canceled for 65,638 shares
during the year ended December 31, 1998.

OLD PLAN ACTIVITY

During 1997 and 1996, the Predecessor Companies granted 1,474,000 and
866,000 options, respectively, under the Old Plans at exercise prices ranging
from $9.53 to $22.58 per share. Total shares issued pursuant to the exercise of
stock options totaled 2,395,000 and 1,051,000 during 1997 and 1996,
respectively.

NOTES RECEIVABLE FROM THE SALE OF COMMON STOCK

The Company provides loans to officers for the exercise of options. The
loans have varying terms not exceeding ten years, bear interest at the
applicable federal interest rate in effect at the date of issue and have been
recorded as a reduction to shareholders' equity. As of March 31, 1999 and
December 31, 1998, 1997 and 1996, the Company had outstanding loans to officers
of $23,735,000, $23,735,000, $29,611,000 and $15,491,000, respectively. Officers
with outstanding loans repaid principal of $0, $5,591,000, $6,534,000, and
$2,199,000 for the three months ended March 31, 1999 and for the years ended
December 31, 1998, 1997 and 1996, respectively. The Company recognized interest
income from these loans of $366,000, $1,600,000, $1,031,000 and $529,000,
respectively, during these same periods.

The Company accounts for its stock options as required by the Accounting
Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees," and
no compensation cost has been recognized. Had compensation cost for the plan
been determined consistent with SFAS No. 123 "Accounting for Stock Based
Compensation," the Company's net increase in net assets resulting from
operations and basic and diluted earnings per common share would have been
reduced to the following pro forma amounts:

<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
-----------------------------------------
1998 1997 1996
--------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C>
Net increase in net assets resulting from operations:
As reported.......................................... $78,078 $61,304 $54,947
Pro forma............................................ $72,684 $60,656 $53,372
Basic earnings per common share:
As reported.......................................... $ 1.50 $ 1.24 $ 1.19
Pro forma............................................ $ 1.39 $ 1.23 $ 1.16
Diluted earnings per common share:
As reported.......................................... $ 1.50 $ 1.24 $ 1.17
Pro forma............................................ $ 1.39 $ 1.23 $ 1.14
</TABLE>

F-28
<PAGE> 101
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 11. STOCK OPTION PLAN, CONTINUED
Pro forma expenses are based on the underlying value of the options granted
by the Company and the Predecessor Companies. The fair value of each option
grant is estimated on the date of grant using the Black-Scholes option pricing
model.

NOTE 12. CUT-OFF AWARD AND FORMULA AWARD

The Predecessor Companies' existing stock option plans were canceled and
the Company established a cut-off dollar amount for all existing, but unvested
options as of the date of the Merger (the "Cut-off Award"). The Cut-off Award is
computed for each unvested option as of the Merger date. The Cut-off Award is
equal to the difference between the market price on August 14, 1997 (the Merger
announcement date) of the shares of stock underlying the option less the
exercise price of the option. The Cut-off Award is payable for each unvested
option upon the future vesting date of that option. The Cut-off Award was
designed to cap the appreciated value in unvested options at the Merger
announcement date, in order to set the foundation to balance option awards upon
the Merger. The Cut-off Award approximates $2.9 million in the aggregate and is
expensed as the Cut-off Award vests. For the three months ended March 31, 1999
and for the year ended December 31, 1998, $212,000 and $807,000 of the Cut-off
Award vested.

The Formula Award was established to compensate employees from the point
when their unvested options would cease to appreciate in value (the Merger
announcement date), up until the time at which they would be able to receive
option awards in ACC post-Merger. In the aggregate, the Formula Award equaled 6
percent of the difference between an amount equal to the combined aggregated
market capitalizations of the Predecessor Companies as of the close of the
market on the day before the Merger date (December 30, 1997), less an amount
equal to the combined aggregate market capitalizations of Allied Lending and the
Predecessor Companies as of the close of the market on the Merger announcement
date. Advisers' compensation committee allocated the Formula Award to individual
officers on December 30, 1997. The amount of the Formula Award as computed at
December 30, 1997 was $18,994,000. This amount was contributed to the Company's
deferred compensation trust under the DC Plan (see Note 10) and was used to
purchase shares of the Company's stock (included in common stock held in
deferred compensation trust). The Formula Award vests equally in three
installments on December 31, 1998, 1999 and 2000; provided, however, that such
Formula Award vests immediately upon a change in control of the Company. The
Formula Award will be expensed in each year in which it vests. For the three
months ended March 31, 1999 and for the year ended December 31, 1998, $1,560,000
and $6,242,000, respectively was expensed as a result of the Formula Award.
Vested Formula Awards are distributable to recipients at the Company's
discretion, however, sale of the Company's stock by the recipients is
restricted. Unvested Formula Awards are forfeited upon a recipient's separation
from service and the related Company stock is retired. For the three months
ended March 31, 1999 and for the year ended December 31, 1998, $61,000 and
$270,000, respectively, of the Formula Award was forfeited.

On January 4, 1999, the Company distributed shares of the Company's common
stock with a value of $4,062,000 representing the portion of the Formula Award
that vested on December 31, 1998.

F-29
<PAGE> 102
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 13. DIVIDENDS AND DISTRIBUTIONS

The Company's Board of Directors declared and the Company paid a $0.40 per
common share dividend, or $23,271,000, for the three months ended March 31,
1999.

For the years ended December 31, 1998, 1997 and 1996, the Company declared
the following distributions:

<TABLE>
<CAPTION>
1998 1997 1996
--------------- --------------- ---------------
TOTAL TOTAL TOTAL
TOTAL PER TOTAL PER TOTAL PER
AMOUNT SHARE AMOUNT SHARE AMOUNT SHARE
------- ----- ------- ----- ------- -----
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C>
First quarter............................ $18,025 $0.35 $14,347 $0.30 $11,158 $0.25
Second quarter........................... 17,966 0.35 14,795 0.30 11,911 0.26
Third quarter............................ 17,976 0.35 15,548 0.31 12,743 0.27
Fourth quarter........................... 19,444 0.35 31,022 0.61 13,678 0.29
Annual extra distribution................ 1,676 0.03 1,118 0.02 7,908 0.16
Special undistributed earnings
distribution........................... -- -- 8,848 0.17 -- --
------- ----- ------- ----- ------- -----
Total distributions to common
shareholders........................... $75,087 $1.43 $85,678 $1.71 $57,398 $1.23
======= ===== ======= ===== ======= =====
</TABLE>

For income tax purposes, distributions for 1998, 1997 and 1996 were
comprised of the following:

<TABLE>
<CAPTION>
1998 1997 1996
--------------- --------------- ---------------
TOTAL TOTAL TOTAL
TOTAL PER TOTAL PER TOTAL PER
AMOUNT SHARE AMOUNT SHARE AMOUNT SHARE
------- ----- ------- ----- ------- -----
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C>
Ordinary income.......................... $49,397 $0.94 $39,356 $0.79 $41,563 $0.89
Long-term capital gains.................. 25,690 0.49 31,037 0.62 15,835 0.34
Return of capital (tax).................. -- -- 6,437 0.13 -- --
------- ----- ------- ----- ------- -----
Total distributions before special
distribution........................... 75,087 1.43 76,830 1.54 57,398 1.23
------- ----- ------- ----- ------- -----
Special undistributed earnings
distribution........................... -- -- 8,848 0.17 -- --
Total distributions to common
shareholders........................... $75,087 $1.43 $85,678 $1.71 $57,398 $1.23
======= ===== ======= ===== ======= =====
</TABLE>

F-30
<PAGE> 103
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 13. DIVIDENDS AND DISTRIBUTIONS, CONTINUED
The following table summarizes the differences between financial statement
net income and taxable income for the years ended December 31, 1998, 1997 and
1996:

<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
Financial statement net income.............................. $78,078 $61,304 $54,947
Adjustments:
Net unrealized (gains) losses.......................... (1,079) (7,209) 7,412
Amortization of discount............................... 2,207 (1,124) (2,779)
Net gain on securitization of commercial mortgage
loans................................................ (14,812) -- --
Interest income from securitized commercial mortgage
loans................................................ 4,910 -- --
Gains from disposition of portfolio assets............. 1,177 17,890 874
Expenses not deductible for tax:
Merger expenses................................... -- 5,159 --
Formula award..................................... 6,242 -- --
Other............................................. 1,393 853 2,306
Other.................................................. (3,029) (9,050) (1,372)
Income tax expense..................................... -- 1,444 1,945
------- ------- -------
Taxable income.............................................. $75,087 $69,267 $63,333
======= ======= =======
</TABLE>

NOTE 14. CONCENTRATIONS OF CREDIT RISK

The Company places its cash with financial institutions and, at times, cash
held in checking accounts in financial institutions may be in excess of the
Federal Deposit Insurance Corporation insured limit. At March 31, 1999 and
December 31, 1998 and 1997, cash and cash equivalents consisted of the
following:

<TABLE>
<CAPTION>
MARCH 31,
1999 1998 1997
----------- ------- --------
(UNAUDITED)
(IN THOUSANDS)
<S> <C> <C> <C>
Cash and cash equivalents...................... $41,930 $31,833 $76,791
Less escrows held.............................. (6,699) (6,758) (6,354)
------- ------- -------
Total.......................................... $35,231 $25,075 $70,437
======= ======= =======
</TABLE>

NOTE 15. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

For the three months ended March 31, 1999 and for the years ended December
31, 1998, 1997 and 1996, the Company paid $2,773,000, $21,708,000, $26,874,000
and $21,391,000, respectively, for interest and income taxes. During 1999, 1998,
1997 and 1996, the Company's non-cash financing activities totaled $1,243,000,
$6,237,000, $48,207,000 and $22,361,000, respectively, related primarily to
common stock issuances resulting from stock option exercises and dividend
reinvestment shares issued. During 1999, 1998, 1997 and 1996, the Company's
non-cash investing activities totaled $0, $1,265,000, $12,022,000 and $2,004,000
respectively.

F-31
<PAGE> 104
ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 16. SELECTED QUARTERLY DATA (UNAUDITED)

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
1998
-------------------------------------
QTR 1 QTR 2 QTR 3 QTR 4
------- ------- ------- -------
<S> <C> <C> <C> <C>
Total interest and related portfolio income............. $36,897 $21,321 $22,546 $25,974
Portfolio income before realized and unrealized gains... $24,920 $ 9,148 $ 9,401 $11,776
Net increase in net assets resulting from operations.... $32,065 $14,476 $14,906 $16,631
Basic earnings per common share......................... $ 0.62 $ 0.28 $ 0.29 $ 0.31
Diluted earnings per common share....................... $ 0.61 $ 0.28 $ 0.29 $ 0.31
</TABLE>

<TABLE>
<CAPTION>
1997
-------------------------------------
QTR 1 QTR 2 QTR 3 QTR 4
------- ------- ------- -------
<S> <C> <C> <C> <C>
Total interest and related portfolio income............. $21,399 $24,911 $25,111 $25,984
Portfolio income before realized and unrealized gains... $11,968 $14,095 $12,093 $ 7,910
Net increase in net assets resulting from operations.... $12,646 $18,296 $17,146 $13,216
Basic earnings per common share......................... $ 0.27 $ 0.37 $ 0.35 $ 0.25
Diluted earnings per common share....................... $ 0.27 $ 0.37 $ 0.35 $ 0.25
</TABLE>

F-32
<PAGE> 105

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATING BALANCE SHEET

<TABLE>
<CAPTION>
DECEMBER 31, 1998
------------------------------------------------------------------------
ALLIED ALLIED CONSOLIDATED
ACC INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL
-------- ---------- ------- -------- ------------ ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
ASSETS
Portfolio at value:
Mezzanine loans and debt securities..... $264,968 $ 74,195 $ -- $ -- $ -- $339,163
Commercial mortgage loans............... 206,463 -- -- 26,723 -- 233,186
Commercial mortgage-backed securities... 32,221 -- -- 81,453 -- 113,674
Small Business Administration 7(a)
loans................................. -- -- 56,285 -- -- 56,285
Equity interests in portfolio
companies............................. 27,641 21,750 -- -- -- 49,391
Investments in subsidiaries............. 159,945 -- -- (335) (159,610) --
Other portfolio assets.................. 277 -- 50 8,248 -- 8,575
-------- -------- ------- -------- --------- --------
Total portfolio at value............ 691,515 95,945 56,335 116,089 (159,610) 800,274
-------- -------- ------- -------- --------- --------
Cash and cash equivalents.................... 5,308 15,068 2,776 1,923 -- 25,075
Intercompany notes and receivables........... 90,194 1,824 90 -- (92,108) --
Other assets................................. 16,822 1,932 9,360 2,734 (118) 30,730
-------- -------- ------- -------- --------- --------
Total assets........................ $803,839 $114,769 $68,561 $120,746 $(251,836) $856,079
======== ======== ======= ======== ========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Debentures and notes payable............ $191,700 $ 47,650 $ -- $ -- $ -- $239,350
Revolving lines of credit............... 95,000 -- -- -- -- 95,000
Accounts payable and other
liabilities........................... 25,003 858 1,655 396 -- 27,912
Dividends and distributions payable..... 1,700 5,085 5,594 -- (10,679) 1,700
Intercompany notes and payables......... 5,319 98 46,116 30,001 (81,534) --
-------- -------- ------- -------- --------- --------
318,722 53,691 53,365 30,397 (92,213) 363,962
-------- -------- ------- -------- --------- --------
Commitments and contingencies
Preferred stock issued to Small Business
Administration............................. -- 7,000 -- -- -- 7,000
Shareholders' equity:
Common stock............................ 6 -- -- 1 (1) 6
Additional paid-in capital.............. 526,824 38,604 17,563 82,294 (138,461) 526,824
Common stock held in deferred
compensation trust.................... (19,431) -- -- -- -- (19,431)
Notes receivable from sale of common
stock................................. (23,735) -- -- -- -- (23,735)
Net unrealized appreciation
(depreciation) on portfolio........... 2,380 1,486 (2,072) (1,503) 2,089 2,380
Undistributed (distributions in excess
of) earnings.......................... (927) 13,988 (295) 9,557 (23,250) (927)
-------- -------- ------- -------- --------- --------
Total shareholders' equity.......... 485,117 54,078 15,196 90,349 (159,623) 485,117
-------- -------- ------- -------- --------- --------
Total liabilities and shareholders'
equity............................ $803,839 $114,769 $68,561 $120,746 $(251,836) $856,079
======== ======== ======= ======== ========= ========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
F-33
<PAGE> 106

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATING STATEMENT OF OPERATIONS

<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31, 1998
-----------------------------------------------------------------------
ALLIED ALLIED CONSOLIDATED
ACC INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL
-------- ---------- ------- ------- ------------ ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Interest and related portfolio
income:
Interest.................. $ 51,247 $11,836 $ 6,257 $10,581 $ -- $ 79,921
Intercompany interest
income.................. 4,846 -- -- -- (4,846) --
Net premiums from loan
dispositions............ 2,920 240 2,789 -- -- 5,949
Net gain on securitization
of commercial mortgage
loans................... -- -- -- 14,812 -- 14,812
Income from investments in
wholly owned
subsidiaries............ 48,873 -- -- -- (48,873) --
Investment advisory fees
and other income........ 4,343 9 837 867 -- 6,056
-------- ------- ------- ------- -------- --------
Total interest and
related portfolio
income.............. 112,229 12,085 9,883 26,260 (53,719) 106,738
-------- ------- ------- ------- -------- --------
Expenses:
Interest on
indebtedness............ 15,092 4,651 711 240 -- 20,694
Intercompany interest on
indebtedness............ -- 503 2,693 1,643 (4,839) --
Salaries and employee
benefits................ 11,829 -- -- -- -- 11,829
General and
administrative.......... 9,417 437 944 1,123 -- 11,921
-------- ------- ------- ------- -------- --------
Total operating
expenses............ 36,338 5,591 4,348 3,006 (4,839) 44,444
-------- ------- ------- ------- -------- --------
Formula and cut-off
awards.................. 7,049 -- -- -- -- 7,049
-------- ------- ------- ------- -------- --------
Portfolio income before realized
and unrealized gains
(losses)...................... 68,842 6,494 5,535 23,254 (48,880) 55,245
-------- ------- ------- ------- -------- --------
Net realized and unrealized
gains:
Net realized gains
(losses)................ 8,156 10,407 (39) 4,017 -- 22,541
Net unrealized gains
(losses)................ 956 (3,502) (1,679) (1,377) 6,681 1,079
-------- ------- ------- ------- -------- --------
Total net realized and
unrealized gains
(losses)............ 9,112 6,905 (1,718) 2,640 6,681 23,620
-------- ------- ------- ------- -------- --------
Income before minority interests
and income taxes.............. 77,954 13,399 3,817 25,894 (42,199) 78,865
-------- ------- ------- ------- -------- --------
Minority interests.............. -- -- -- -- -- --
Income tax expense.............. -- -- -- 787 -- 787
-------- ------- ------- ------- -------- --------
Net increase in net assets
resulting from operations..... $ 77,954 $13,399 $ 3,817 $25,107 $(42,199) $ 78,078
======== ======= ======= ======= ======== ========
</TABLE>

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

F-34
<PAGE> 107

ALLIED CAPITAL CORPORATION AND SUBSIDIARIES

CONSOLIDATING STATEMENT OF CASH FLOWS

<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31, 1998
--------------------------------------------------------------------------
ALLIED ALLIED CONSOLIDATED
ACC INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL
--------- ---------- -------- -------- ------------ ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net increase in net assets resulting
from operations..................... $ 77,954 $ 13,399 $ 3,817 $ 25,107 $(42,199) $ 78,078
Adjustments
Net unrealized (gains) losses....... (956) 3,502 1,679 1,377 (6,681) (1,079)
Net gain on securitization of
commercial mortgage loans......... -- -- -- (14,812) -- (14,812)
Depreciation and amortization....... 702 -- -- -- -- 702
Amortization of loan discounts and
fees.............................. (4,741) (583) (708) -- -- (6,032)
Changes in other assets and
liabilities....................... 3,267 908 (2,329) 10,152 -- 11,998
--------- -------- -------- -------- -------- ---------
Net cash provided by operating
activities...................... 76,226 17,226 2,459 21,824 (48,880) 68,855
--------- -------- -------- -------- -------- ---------
Cash flows from investing activities:
Investments in small business
concerns.......................... (426,797) (18,870) (57,725) (25,333) 4,195 (524,530)
Collections of investment
principal......................... 112,535 21,210 4,183 153 -- 138,081
Proceeds from loan sales............ 44,063 -- 36,950 -- -- 81,013
Proceeds from securitization of
commercial mortgage loans......... 223,401 -- -- -- -- 223,401
Net (purchase) redemption of U.S.
government securities............. -- 11,091 -- -- -- 11,091
Collections (advances) under
intercompany notes................ (42,170) (19,756) 34,458 27,468 -- --
Collections of notes receivable from
sale of common stock.............. 5,591 -- -- -- -- 5,591
Other investing activities.......... (2,539) -- -- -- -- (2,539)
--------- -------- -------- -------- -------- ---------
Net cash (used in) provided by
investing activities............ (85,916) (6,325) 17,866 2,288 4,195 (67,892)
--------- -------- -------- -------- -------- ---------
Cash flows from financing activities:
Sale of common stock................ 69,896 -- -- -- -- 69,896
Purchase of common stock by deferred
compensation trust................ (19,431) -- -- -- -- (19,431)
Purchase of common stock of
subsidiaries...................... (5,000) -- 5,000 -- -- --
Common dividends and distributions
paid.............................. (69,536) -- -- -- -- (69,536)
Special undistributed earnings
distribution paid................. (8,848) -- -- -- -- (8,848)
Dividends paid to parent company.... -- (22,204) (5,594) (16,887) 44,685 --
Preferred stock dividends........... -- (450) -- -- -- (450)
Net payments on debentures and notes
payable........................... (53,871) (15,600) -- -- -- (69,471)
Net borrowings under revolving lines
of credit......................... 74,706 -- (18,548) -- -- 56,158
Other financing activities.......... 1,124 -- -- (5,767) -- (4,643)
--------- -------- -------- -------- -------- ---------
Net cash used in financing
activities...................... (10,960) (38,254) (19,142) (22,654) 44,685 (46,325)
--------- -------- -------- -------- -------- ---------
Net (decrease) increase in cash and cash
equivalents............................. (20,650) (27,353) 1,183 1,458 -- (45,362)
--------- -------- -------- -------- -------- ---------
Cash and cash equivalents at beginning of
year.................................... 25,958 42,421 1,593 465 -- 70,437
--------- -------- -------- -------- -------- ---------
Cash and cash equivalents at end of
year.................................... $ 5,308 $ 15,068 $ 2,776 $ 1,923 $ -- $ 25,075
========= ======== ======== ======== ======== =========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
F-35
<PAGE> 108

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES:

We have audited the consolidated balance sheet of Allied Capital
Corporation and subsidiaries as of December 31, 1998 and 1997, including the
consolidated statement of investments as of December 31, 1998, and the related
consolidated statements of operations, changes in net assets and cash flows for
each of the three years in the period ended December 31, 1998. These
consolidated financial statements and supplementary consolidating financial
information referred to below are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements and supplementary consolidating financial information
referred to below based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. These procedures
included physical counts of investments. 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Allied
Capital Corporation and subsidiaries as of December 31, 1998 and 1997, and the
consolidated results of their operations, changes in net assets and cash flows
for each of the three years in the period then ended in conformity with
generally accepted accounting principles.

As discussed in Note 3, the consolidated financial statements include
investments valued at $800,274,000 as of December 31, 1998 and $697,021,000 as
of December 31, 1997, (93 percent and 86 percent, respectively, of total assets)
whose values have been estimated by the board of directors in the absence of
readily ascertainable market values. We have reviewed the procedures used by the
board of directors in arriving at its estimate of value of such investments and
have inspected the underlying documentation, and in the circumstances we believe
the procedures are reasonable and the documentation appropriate. However,
because of the inherent uncertainty of valuation, the board of directors'
estimate of values may differ significantly from the values that would have been
used had a ready market existed for the investments, and the differences could
be material.

Our audit was made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. The supplementary
consolidating balance sheet and related consolidating statements of operations
and cash flows are presented for purposes of additional analysis and are not a
required part of the basic financial statements. This information has been
subjected to the auditing procedures applied in our audit of the basic
consolidated financial statements and in our opinion, is fairly stated in all
material respects in relation to the basic financial statements taken as a
whole.

/s/ Arthur Anderson LLP

Vienna, Virginia
February 18, 1999

F-36
<PAGE> 109

THE INFORMATION IN THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT COMPLETE AND
MAY BE CHANGED. WE MAY NOT SELL THESE SECURITIES UNTIL THE REGISTRATION
STATEMENT FILED WITH THE SECURITIES AND EXCHANGE COMMISSION IS EFFECTIVE. THIS
STATEMENT OF ADDITIONAL INFORMATION IS NOT AN OFFER TO SELL THESE SECURITIES AND
IS NOT SOLICITING AN OFFER TO BUY THESE SECURITIES IN ANY STATE WHERE THE OFFER
OR SALE IS NOT PERMITTED.

SUBJECT TO COMPLETION 1999.

ALLIED CAPITAL CORPORATION

STATEMENT OF ADDITIONAL INFORMATION
, 1999

-------------------------

This Statement of Additional Information ("SAI") is not a prospectus, and
should be read in conjunction with the prospectus dated , 1999
relating to this offering and the accompanying prospectus supplement, if any.
You can obtain a copy of the prospectus by calling Allied Capital Corporation at
1-888-818-5298 and asking for Investor Relations. Terms not defined herein have
the same meaning as given to them in the prospectus.

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE IN THE LOCATION
STATEMENT OF RELATED
OF ADDITIONAL DISCLOSURE IN
INFORMATION THE PROSPECTUS
------------- --------------
<S> <C> <C>
General Information and History............................. B-2 1;11;35
Investment Objective and Policies........................... B-2 1;11;35
Management.................................................. B-2 51
Compensation of Executive Officers and Directors....... B-2 54
Compensation of Directors.............................. B-3 54
Stock Option Awards.................................... B-4 54
Cut-Off Award and Formula Award........................ B-4 54
Committees of the Board of Directors................... B-6 N/A
Control Persons and Principal Holders of Securities......... B-7 N/A
Investment Advisory Services................................ B-8 51
Safekeeping, Transfer and Dividend Paying Agent and
Registrar................................................. B-8 66
Accounting Services......................................... B-8 66
Brokerage Allocation and Other Practices.................... B-8 N/A
Tax Status.................................................. B-9 56
</TABLE>

-------------------------
B-1
<PAGE> 110

GENERAL INFORMATION AND HISTORY

This SAI contains information with respect to Allied Capital Corporation
(the "Company"). The Company changed its name from "Allied Capital Lending
Corporation" to "Allied Capital Corporation," effective upon the merger, which
was consummated on December 31, 1997. The Company is a registered investment
adviser. The Company was initially organized as a corporation in the District of
Columbia in 1976 and was reincorporated in the state of Maryland in 1990.

INVESTMENT OBJECTIVE AND POLICIES

The investment objective of the Company is to achieve current income and
capital gains. The Company seeks to achieve its investment objective by lending
to and investing primarily in private, growing businesses in a variety of
industries and in diverse geographic locations primarily in the United States.
We focus on investments in three primary areas: mezzanine finance, commercial
real estate finance and SBA 7(a) lending. Our investment portfolio consists
primarily of small and medium-sized subordinated loans with equity features,
small and medium-sized commercial mortgage loans, commercial mortgage-backed
securities, and small senior loans. At March 31, 1999, our investment portfolio
totaled $885.8 million. A discussion of the selected financial data,
supplementary financial information and management's discussion and analysis of
financial condition and results of operations is included in the prospectus. In
addition to its core lending business, the Company also provides advisory
services to private investment funds.

MANAGEMENT

COMPENSATION OF EXECUTIVE OFFICERS AND DIRECTORS

Under Commission rules applicable to BDCs, we are required to set forth
certain information regarding the compensation of certain executive officers and
directors. The following table sets forth compensation paid by the Company in
all capacities during the year ended December 31, 1998, to the directors and the
three highest paid executive officers of the Company (collectively, the
"Compensated Persons").

B-2
<PAGE> 111

COMPENSATION TABLE

<TABLE>
<CAPTION>
PENSION OR
AGGREGATE SECURITIES RETIREMENT BENEFITS DIRECTORS FEES
COMPENSATION FROM UNDERLYING ACCRUED AS PART OF PAID BY THE
NAME AND POSITION THE COMPANY(1) OPTIONS/SARs(4) COMPANY EXPENSES COMPANY(5)
----------------- ----------------- --------------- ------------------- --------------
<S> <C> <C> <C> <C>
William L. Walton, Chairman and Chief
Executive Officer(2)*................ $2,158,599 754,188 $ -- $17,667
Joan M. Sweeney, Managing
Director(2).......................... 1,178,920 374,275 -- 0
G. Cabell Williams III, Managing
Director(2).......................... 896,873 278,403 -- 0
Brooks H. Browne, Director............. 10,500 -- -- 10,500
John D. Firestone, Director............ 11,500 -- -- 11,500
Anthony T. Garcia, Director............ 12,500 -- -- 12,500
Lawrence I. Hebert, Director........... 8,500 -- -- 8,500
John I. Leahy, Director................ 17,167 -- -- 17,167
Robert E. Long, Director............... 18,667 -- -- 18,667
Warren K. Montouri, Director........... 15,667 -- -- 15,667
Guy T. Steuart II, Director............ 11,000 -- -- 11,000
T. Murray Toomey, Director............. 7,500 -- -- 7,500
Laura W. van Roijen, Director.......... 8,500 -- -- 8,500
George C. Williams, Jr. Director,
Chairman Emeritus(3)*................ 626,206 151,395 -- 18,167
</TABLE>

- -------------------------

* Interested persons of the Company, as defined in the 1940 Act.

(1) There were no perquisites paid by the Company in excess of the lesser of
$50,000 or 10% of the Compensated Person's total salary and bonus for the
year.
(2) The following table provides detail for 1998 as to the aggregate
compensation of the three highest paid executive officers of the Company.

<TABLE>
<CAPTION>
VESTED DEFERRED
FORMULA CUT-OFF ESOP COMPENSATION DIRECTORS
SALARY BONUS AWARD AWARD CONTRIBUTION CONTRIBUTION FEES
-------- -------- ---------- -------- ------------ ------------ ---------
<S> <C> <C> <C> <C> <C> <C> <C>
Mr. Walton............ $351,517 $525,000 $1,056,683 $170,156 $8,000 $29,576 $17,667
Ms. Sweeney........... 222,191 275,000 619,154 38,965 8,000 15,610 --
G. Cabell Williams
III................. 225,327 275,000 287,523 88,257 8,000 12,766 --
</TABLE>

The Formula Award, which totaled approximately $19 million in the aggregate,
vests in three equal installments on December 31, 1998, 1999, and 2000, and
will be expensed for financial reporting purposes similarly. The amount of
the Formula Award expensed in 1998 for financial reporting purposes for Mr.
Walton, Ms. Sweeney and Mr. Williams was $1,472,451, $862,761 and $400,664,
respectively. The amount expensed was based on the value of the Formula Award
contribution to the deferred compensation plan in January 1998. On January 4,
1999, the first vested installment of the Formula Award was generally
distributed to participants at the market value of the Company's common stock
on that day. The distribution amount for Mr. Walton, Ms. Sweeney and Mr.
Williams was $1,056,683, $619,154 and $287,523, respectively. The Company
distributed the vested shares to brokerage accounts for the participants that
restrict the sale of the vested shares.

The Cut-Off Award, which totaled $2.9 million in the aggregate, will be paid
to individuals on the respective vesting date of any options under the Old
Plans which were canceled in connection with the merger. See "-- Cut-Off
Award and Formula Award."

(3) In addition to director's fees, Mr. Williams received $144,000 in consulting
fees, $32,686 in Cut-Off Award and $431,353 in vested Formula Award. The
amount of the Formula Award expensed in 1998 for Mr. Williams was $601,068.
(4) See "Stock Option Awards" for terms of options granted in 1998. The Company
does not maintain a restricted stock plan or a long-term incentive plan.
(5) Consists only of directors' fees paid by the Company during 1998. Such fees
are also included in the column titled "Aggregate Compensation from the
Company."

COMPENSATION OF DIRECTORS

During the first quarter of 1998, each director received a fee of $1,000
for each meeting of the board of directors or any separate committee meeting
attended, and $500 for each committee meeting attended on the same day as a
board of directors meeting. Beginning in April 1998, each director received
$1,000 for each board or committee meeting attended, except with respect to the
members
B-3
<PAGE> 112

of the executive committee, who each received an annual retainer of $10,000 in
lieu of fees paid for each executive committee meeting attended. For 1998, this
annual retainer was prorated. Non-officer directors are eligible for stock
option awards under the Company's current stock option plan, provided that the
Commission grants exemptive relief to permit such awards. No grants have been
made to non-officer directors under the Company's stock option plan. See
"-- Stock Option Awards" and "Management -- Compensation Plans -- Stock Option
Plan" in the prospectus.

STOCK OPTION AWARDS

The following table sets forth the details relating to option grants in
1998 to the Company's Compensated Persons and the potential realizable value of
each grant, as prescribed to be calculated by the Commission.

OPTION GRANTS DURING 1998

<TABLE>
<CAPTION>
POTENTIAL REALIZABLE
VALUE AT ASSUMED ANNUAL
NUMBER OF PERCENT RATES OF
SECURITIES OF TOTAL EXERCISE STOCK APPRECIATION
UNDERLYING OPTIONS PRICE OVER 10-YEAR TERM(3)
OPTIONS GRANTED PER EXPIRATION ------------------------
NAME GRANTED(1) IN 1998(2) SHARE DATE 5% 10%
---- ---------- ---------- -------- ---------- ---------- -----------
<S> <C> <C> <C> <C> <C> <C>
William L. Walton......... 659,188 12.7% $21.375 1/8/08 $8,861,216 $22,456,060
95,000 1.8 $17.875 12/8/08 $1,067,942 $ 2,706,374
Joan M. Sweeney........... 319,275 6.2 $21.375 1/8/08 $4,291,893 $10,876,500
55,000 1.1 $17.875 12/8/08 $ 618,282 $ 1,566,848
G. Cabell Williams III.... 223,403 4.3 $21.375 1/8/08 $3,003,122 $ 7,610,501
55,000 1.1 $17.875 12/8/08 $ 618,282 $ 1,566,848
George C. Williams,
Jr. .................... 141,395 2.7 $21.375 1/8/08 $1,900,720 $ 4,816,797
10,000 0.2 $17.875 12/8/08 $ 112,415 $ 284,881
</TABLE>

- -------------------------
(1) Options granted in 1998 generally vest in six equal installments beginning
on the date of grant, with full vesting occurring on the fifth anniversary
of the grant date or change of control of the Company.

(2) In 1998, the Company granted options to purchase a total of 5,189,944
shares.

(3) Potential realizable value is calculated on 1998 options granted, and is net
of the option exercise price but before any tax liabilities that may be
incurred. These amounts represent certain assumed rates of appreciation, as
mandated by the Commission. Actual gains, if any, or stock option exercises
are dependent on the future performance of the shares, overall market
conditions, and the continued employment by the Company of the option
holder. The potential realizable value will not necessarily be realized.

CUT-OFF AWARD AND FORMULA AWARD

As discussed in the prospectus, prior to the merger options had been
granted under the Old Plans to various employees of Advisers, who were also
officers of the predecessor companies. In preparation for the merger, the
compensation committee of Advisers, in conjunction with the compensation
committee of the other predecessor companies, determined that the five Old Plans
should be terminated upon the merger, so that the new merged Company would be
able to develop a new plan that would incent all officers and directors with a
single equity security. The existence of the Old Plans had resulted in certain
inequities in option grants among the various officers of the predecessor
companies simply because of the differences in the underlying equity securities.

To balance stock option awards among employees, and to account for the
deviations caused by the existence of five plans by five different publicly
traded stocks, two special awards were developed to be granted in lieu of
options under the Old Plans that were foregone upon the merger and the
cancellation of the Old Plans.

B-4
<PAGE> 113

Cut-Off Award. The first award established a cut-off dollar amount as of
the date of the announcement of the merger (August 14, 1997) that was computed
for all outstanding, but unvested options that were canceled as of the date of
the merger (the "Cut-Off Award"). The Cut-Off Award was designed to cap the
appreciated value in unvested options as of the merger announcement date in
order to set the foundation to balance option awards upon the merger. The
Cut-Off Award, in the aggregate, was computed to be $2.9 million, and is equal
to the difference between the market price of the shares of stock underlying the
canceled options under the Old Plans at August 14, 1997, less the exercise
prices of the options. The Cut-Off Award is payable for each canceled option as
the canceled options would have vested and will vest automatically in the event
of a change of control. The Cut-Off Award is only payable if the award recipient
is employed by the Company on the future vesting date. The following table
indicates the Cut-Off Award for each Compensated Person, and the related vesting
schedule.

<TABLE>
<CAPTION>
CUT-OFF AWARD
RECIPIENT 1998 1999 2000 2001 2002
- ---------------------------------------------- -------- -------- -------- ------- -------
<S> <C> <C> <C> <C> <C>
William L. Walton............................. $170,157 $170,157 $170,157 $ 0 $ 0
Joan M. Sweeney............................... 38,964 37,678 36,602 2,026 0
G. Cabell Williams III........................ 88,257 46,802 39,677 21,152 18,916
George C. Williams, Jr........................ 32,686 4,688 52,373 0 0
</TABLE>

Formula Award. The second award (the "Formula Award") was designed to
compensate officers from the point when their unvested options ceased to
appreciate in value pursuant to the Cut-Off Award (i.e., August 14, 1997) up
until the time at which they would be able to receive option awards in the
Company after the merger became effective. In the aggregate, the Formula Award
equaled six percent (6%) of the difference between the combined aggregate market
capitalizations of the predecessor companies as of the close of the market on
December 30, 1997, and the combined aggregate market capitalizations of the
predecessor companies on August 14, 1997. In total, the combined aggregate
market capitalization of the predecessor companies increased by $319 million
from August 14, 1997 to December 30, 1997, and the aggregate Formula Award was
approximately $19 million.

The Formula Award was designed as a long-term incentive compensation
program to be a replacement for canceled stock options and to balance share
ownership among key officers for past and prospective service. The terms of the
Formula Award required that the award be contributed to the Company's deferred
compensation plan, and be used to purchase shares of the Company in the open
market.

The Formula Award vests and accrues equally over a three-year period, on
the anniversary of the merger date (December 31, 1997), and vests automatically
in the event of a change of control of the Company. If an officer terminates
employment with the Company prior to the vesting of any part of the Formula
Award, that amount will be forfeited to the Company. Assuming all officers meet
the vesting requirement, the Company will accrue the Formula Award over the
three-year period in equal amounts of approximately $6.4 million, less any
forfeitures. For the year ended December 31, 1998, $6.2 million, net of
forfeitures of $0.3 million, was expensed for the Formula Award. The following
table indicates the Formula Award for each Compensated Person, and the related
vesting schedule.

<TABLE>
<CAPTION>
FORMULA AWARD RECIPIENT 1998 1999 2000
----------------------- ---------- ---------- ----------
<S> <C> <C> <C>
William L. Walton..................................... $1,472,451 $1,472,451 $1,472,451
Joan M. Sweeney....................................... 862,761 862,761 862,761
G. Cabell Williams III................................ 400,664 400,664 400,664
George C. Williams, Jr................................ 601,068 601,068 601,068
</TABLE>

B-5
<PAGE> 114

On January 4, 1999, the portion of the Formula Award that vested on
December 31, 1998 was generally distributed to participants in the form of
shares of the Company's common stock. These shares are held in restricted
accounts at a brokerage firm.

COMMITTEES OF THE BOARD OF DIRECTORS

The Company's board of directors has established an Executive Committee, an
Audit Committee, a Nominating Committee and a Compensation Committee.

The Executive Committee has and may exercise those rights, powers and
authority of the board of directors as the board of directors may from time to
time grant to it, except where action by the board of directors is required by
statute, an order of the Commission or the Company's charter or bylaws. In
addition, the Executive Committee is authorized to approve all investments over
$10 million, or any investment that possesses unusual risk/reward
characteristics. The Executive Committee consists of Messrs. Walton, Leahy,
Long, Montouri, and Williams. The Executive Committee met sixteen times during
1998.

The Audit Committee recommends the selection of independent public
accountants for the Company, reviews with such independent public accountants
the planning, scope and results of their audit of the Company's financial
statements and the fees for services performed, reviews with the independent
public accountants the adequacy of internal control systems, reviews the annual
financial statements and receives the Company's audit reports and financial
statements. The Audit Committee consists of Messrs. Browne, Leahy and Steuart.
The Audit Committee met twice during 1998.

The Compensation Committee determines the compensation for the Company's
executive officers and the amount of salary and bonus to be included in the
compensation package for each of the Company's officers and employees. In
addition, the Compensation Committee approves stock option grants for the
Company's officers under the Company's Stock Option Plan. The Compensation
Committee consists of Messrs. Browne, Long, Firestone and Garcia. The
Compensation Committee met four times during 1998.

The Nominating Committee recommends candidates for election as directors.
The Nominating Committee consists of Messrs. Walton, Hebert, Toomey and Steuart,
and Ms. van Roijen. The Nominating Committee met once in 1998.

B-6
<PAGE> 115

CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES

As of April 30, 1999, there were no persons that owned 25% or more of the
Company's outstanding voting securities, and no person would be deemed to
control the Company, as such term is defined in the 1940 Act.

The following table sets forth, at April 30, 1999, the beneficial ownership
of the shareholders owning 5% or more of the common stock outstanding as well as
each current director, the Chief Executive Officer, the Company's executive
officers, and the executive officers and directors as a group. The address for
each director and executive officer is 1919 Pennsylvania Avenue, NW, Washington,
DC 20006. Unless otherwise indicated, the Company believes that each beneficial
owner set forth in the table has sole voting and investment power.

<TABLE>
<CAPTION>
NAME OF NUMBER OF SHARES PERCENTAGE OF
BENEFICIAL OWNER OWNED BENEFICIALLY CLASS (1)
- ------------------------------------------------------ ------------------ -------------
<S> <C> <C>
Wallace R. Weitz and Company 1125 South 103rd Street
Omaha, NE 68124 3,167,000 5.4%
DIRECTORS:
William L. Walton..................................... 799,079(2,3) 1.4%
Brooks H. Browne...................................... 40,098 *
John D. Firestone..................................... 20,161 *
Anthony T. Garcia..................................... 52,507 *
Lawrence I. Hebert.................................... 16,800 *
John I. Leahy......................................... 16,818 *
Robert E. Long........................................ 9,796 *
Warren K. Montouri.................................... 206,182 *
Guy T. Steuart II..................................... 318,180(4) *
T. Murray Toomey, Esq................................. 32,666(5) *
Laura W. van Roijen................................... 28,302 *
George C. Williams, Jr................................ 380,277(2) *
EXECUTIVE OFFICERS:
Philip A. McNeill..................................... 196,699(2) *
Penni F. Roll......................................... 64,840(2) *
John M. Scheurer...................................... 370,449(2) *
Joan M. Sweeney....................................... 320,465(2) *
G. Cabell Williams III................................ 751,582(2,3) 1.3%
All directors and executive officers as a group (17 in
number)............................................. 3,283,537(6) 5.5%
</TABLE>

- -------------------------
* Less than 1%

(1) Based on a total of 58,817,435 shares of the Company's common stock issued
and outstanding on April 30, 1999 and shares of the Company's common stock
issuable upon the exercise of immediately exercisable stock options held by
each individual executive officer. At this time, no options have been
granted to non-officer directors.

(2) Share ownership for the following directors and executive officers includes:

<TABLE>
<CAPTION>
OPTIONS
EXERCISABLE ALLOCATED
OWNED WITHIN 60 DAYS TO ESOP
DIRECTLY OF APRIL 30, 1999 ACCOUNT
-------- ----------------- ---------
<S> <C> <C> <C>
Mr. Walton................................................ 261,566 235,564 693
Mr. Williams, Jr.......................................... 284,346 95,931 --
Mr. McNeill............................................... 112,337 76,677 7,685
Ms. Roll.................................................. 35,975 25,959 2,906
Mr. Scheurer.............................................. 235,267 114,876 20,306
Ms. Sweeney............................................... 196,355 115,592 8,518
Mr. Williams III.......................................... 365,998 83,635 64,127
</TABLE>

(3) Includes 301,949 shares held by the ESOP, of which Messrs. Walton and
Williams III are co-trustees. Participants in the ESOP may direct the voting
of these shares; however, if a participant does not direct the voting, the
co-trustees of the ESOP will vote the shares on behalf of the participants.
Messrs. Walton and Williams III disclaim beneficial ownership of such
shares. As of March 31, 1998, all shares held in the ESOP had been
allocated, except for 23,508 shares purchased in 1999.

B-7
<PAGE> 116

(4) Includes 276,691 shares held by a corporation for which Mr. Steuart serves
as an executive officer.

(5) Shares are held by a trust for the benefit of Mr. Toomey and his wife.

(6) Includes a total of 748,234 shares underlying stock options exercisable
within 60 days of March 19, 1999, which are assumed to be outstanding for
the purpose of calculating the group's percentage ownership, and 301,949
shares held by the ESOP.

INVESTMENT ADVISORY SERVICES

The Company is internally managed and therefore has not entered into any
advisory agreement with, nor pays advisory fees to, an outside investment
adviser. The Company is a registered investment adviser under the Advisers Act
and provides advisory services to other entities. The Company currently has 75
investment and other portfolio management professionals, who manage the
investments of the Company as well as the investments of other managed entities,
as well as 33 other professional employees and staff. All investments of the
Company must be approved by the Company's investment committee, or a
subcommittee thereof, which is composed of senior investment professionals of
the Company. In addition, in certain instances where risk/return characteristics
warrant and for every transaction larger than $10 million, the executive
committee of the board of directors must also approve the transaction. See
"Management" in the prospectus.

SAFEKEEPING, TRANSFER AND DIVIDEND PAYING AGENT AND REGISTRAR

The investments of the Company and its subsidiaries are held in safekeeping
by Riggs Bank N.A. ("Riggs") at 808 17th Street, N.W., Washington, D.C. 20006.
LaSalle National Bank, located at 25 Northwest Point Boulevard, Suite 800, Elk
Grove Village, Illinois 60007, serves as the trustee and custodian with respect
to assets of the Company held for securitization purposes. American Stock
Transfer & Trust Company, 40 Wall Street, 46th Floor, New York, New York 10005
acts as the Company's transfer, dividend paying and reinvestment plan agent and
registrar.

ACCOUNTING SERVICES

Arthur Andersen LLP ("Andersen") has served as the independent accountant
to the Company since December 31, 1997. Prior to the year ended December 31,
1997, Allied Lending's financial statements were audited by Matthews, Carter and
Boyce, P.C., or its predecessor ("Matthews"). On December 12, 1997, Matthews
resigned, effective upon the consummation of the merger, and Andersen was
engaged and continues as the independent accountants of the Company. The
decision to change accountants was recommended by the Company's Audit Committee
and was approved by the board of directors of the Company.

For the year ended December 31, 1996, and up to the date of resignation of
Matthews, there were no disagreements with Matthews on any matter of accounting
principles or practices, financial statement disclosure or auditing scope or
procedure which, if not resolved to the satisfaction of Matthews, would have
caused it to make reference to the subject matter of the disagreement in
connection with its report. The independent accountants' report on the 1996
financial statements did not contain an adverse opinion or a disclaimer of
opinion, and was not qualified or modified as to uncertainty, audit scope or
accounting principles. Each of Andersen and Matthews has advised the Company
that neither it nor any present member or associate of the relevant firm has any
financial interest, direct or indirect, in the Company or its subsidiaries.

BROKERAGE ALLOCATION AND OTHER PRACTICES

Since the Company generally acquires and disposes of its investments in
privately negotiated transactions, it infrequently uses brokers in the normal
course of business.

B-8
<PAGE> 117

TAX STATUS

The following discussion is a general summary of the material federal
income tax considerations applicable to the Company and to an investment in the
common stock and does not purport to be a complete description of the income tax
considerations applicable to such an investment. The discussion is based upon
the Code, Treasury Regulations, and administrative and judicial interpretations,
each as of the date of this SAI and all of which are subject to change. You
should consult your own tax advisor with respect to tax considerations which
pertain to your purchase of common stock.

The Company. The Company has elected for each taxable year to be treated
as a "regulated investment company" or "RIC" under Subchapter M of the Code and
intends to continue to maintain that status. If the Company qualifies as a RIC
and distributes to stockholders in a timely manner at least 90% of its
"investment company taxable income," as defined in the Code (i.e., net
investment income, including accrued original issue discount, and net short-term
capital gains) (the "90% Distribution Requirement") each year, it will not be
subject to federal income tax on the portion of its investment company taxable
income and net capital gains (net long-term capital gain in excess of net
short-term capital loss) it distributes to stockholders. In addition, if the
Company distributes in a timely manner 98% of its capital gain net income for
each one-year period ending on December 31, and distributes 98% of its net
ordinary income for each 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. The Company
generally endeavors to distribute to stockholders all of its investment company
taxable income and its net capital gain, if any, for each taxable year so that
such Company will not incur income and excise taxes on its earnings.

In order to qualify as a RIC for federal income tax purposes, the Company
must, among other things: (a) continue to qualify as a BDC under the 1940 Act,
(b) derive in each taxable year 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 (the "90% Income Test"); and (c)
diversify its holdings so that at the end of each quarter of the taxable year
(i) at least 50% of the value of the Company's assets consists of cash, cash
items, U.S. 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 or 10% of the outstanding voting securities of the
issuer, and (ii) no more than 25% of the value of the Company's assets is
invested in the securities of one issuer (other than U.S. government securities
or securities of other RICs) or of two or more issuers that are controlled (as
determined under applicable Code rules) by the Company and are engaged in the
same or similar or related trades or businesses. The failure of one or more of
the Company's subsidiaries to continue to qualify as RICs could adversely affect
the Company's ability to satisfy the foregoing diversification requirements.

If the Company acquires or is deemed to have acquired debt obligations that
were issued originally at a discount or that otherwise are treated under
applicable tax rules as having original issue discount, it must include in
income each year a portion of the original issue discount that accrues over the
life of the obligation regardless of whether cash representing such income is
received by the relevant entity in the same taxable year and to make
distributions accordingly.

B-9
<PAGE> 118

Although it does not presently expect to do so, the Company is authorized
to borrow funds and to sell assets in order to satisfy distribution
requirements. However, under the 1940 Act, the Company is not permitted to make
distributions to stockholders while the Company's debt obligations and other
senior securities are outstanding unless certain "asset coverage" tests are met.
Moreover, the Company's ability to dispose of assets to meet its distribution
requirements may be limited by other requirements relating to its status as a
RIC, including the diversification requirements. If the Company disposes of
assets in order to meet distribution requirements, the Company may make such
dispositions at times which, from an investment standpoint, are not
advantageous.

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 that year on all of its taxable income, regardless of whether it makes
any distributions to its stockholders. In that case, all of the Company's
distributions to its stockholders will be characterized as ordinary income (to
the extent of the Company's current and accumulated earnings and profits). In
contrast, as is explained below, if the Company qualifies as a RIC, a portion of
its distributions may be characterized as long-term capital gain in the hands of
stockholders.

U.S. Stockholders. Other than distributions properly designated as
"capital gain dividends" as is described below, dividends to U.S. Stockholders
(as defined below) of the investment company taxable income of the Company will
be taxable as ordinary income to stockholders to the extent of the Company's
current or accumulated earnings and profits, whether paid in cash or reinvested
in additional shares. A "U.S. Stockholder" is a stockholder who is (i) a citizen
or resident of the United States, (ii) a corporation, partnership or other
entity created in or organized under the laws of the United States or any
political subdivision thereof, (iii) an estate, the income of which is subject
to United States federal income taxation regardless of its source, or (iv) a
trust subject to the supervision of a court within the United States and the
control of a United States person. Distributions of the Company's net capital
gain properly designated by the Company as "capital gain dividends" will be
taxable to stockholders as a long-term capital gain regardless of the
stockholder's holding period for his or her shares. Distributions in excess of
the Company's earnings and profits will first reduce the adjusted tax basis of
the stockholder's shares and, after the adjusted basis is reduced to zero, will
constitute capital gains to the stockholder. For a summary of the tax rates
applicable to capital gains, including capital gains dividends, see discussion
below.

To the extent that the Company retains any net capital gain, it may
designate such retained gain as "deemed distributions" and pay a tax thereon for
the benefit of its stockholders. In that event, the stockholders will be
required to report their share of retained net capital gain on their tax returns
as if it had been distributed to them and report a credit, or claim or refund
for the tax paid thereon by the Company. The amount of the deemed distribution
net of such tax will be added to the stockholder's cost basis for his or her
shares. Since the Company expects to pay tax on net capital gain at its regular
corporate capital gain tax rate, and since that rate is in excess of the maximum
rate currently payable by individuals on net capital gain, the amount of tax
that individual stockholders will be treated as having paid will exceed the
amount of tax that such stockholders would be required to pay on net capital
gain. Stockholders who are not subject to federal income tax or tax on capital
gains should be able to file a Form 990T or an income tax return on the
appropriate form that allows them to recover the taxes paid on their behalf.

Any dividend declared by the Company in October, November, or December of
any calendar year, payable to stockholders of record on a specified date in such
a month and actually paid during January of the following year, will be treated
as if it had been received by the stockholders on December 31 of the year in
which the dividend was declared.

You should consider the tax implications of buying shares just prior to a
distribution. Even if the price of the shares includes the amount of the
forthcoming distribution, you may be taxed upon

B-10
<PAGE> 119

receipt of the distribution and will not be entitled to offset the distribution
against the tax basis in your shares.

You may recognize taxable gain or loss if you sell or exchange your shares.
Any gain arising from (or, in the case of distributions in excess of earnings
and profits, treated as arising from) the sale or exchange of shares generally
will be a capital gain or loss. This capital gain or loss normally will be
treated as a long-term capital gain or loss if you have held your shares for
more than one year; otherwise, it will be classified as short-term capital gain
or loss. However, any capital loss arising from the sale or exchange of shares
held for six months or less will be treated as a long-term capital loss to the
extent of the amount of capital gain dividends received with respect to such
shares and, for this purpose, the special rules of Section 246(c)(3) and (4) of
the Code generally apply in determining the holding period of shares. It is
unclear how any such long-term capital loss offsets capital gains taxable at
different rates. All or a portion of any loss realized upon a taxable
disposition of shares of the Company may be disallowed if other shares of the
Company are purchased (under a DRIP plan or otherwise) within 30 days before or
after the disposition.

In general, net capital gain derived from an investment in the Company (the
excess of net long-term capital gain over net short-term capital loss) of
non-corporate taxpayers currently is subject to a maximum federal income tax
rate of 20% (subject to reduction in certain situations) while other income may
be taxed at rates as high as 39.6%. Capital gains derived from the disposition
of assets held for more than 18 months generally are subject to federal income
tax at the rate of 20%. Corporate taxpayers currently are subject to federal
income tax on net capital gain at the maximum 35% rate also applied to ordinary
income. Tax rates imposed by states and local jurisdictions on capital gain and
ordinary income may differ.

The Company will send to each of its stockholders, as promptly as possible
after the end of each fiscal year, a notice detailing, on a per share and per
distribution basis, the amounts includible in such stockholder's taxable income
for such year as ordinary income and as long-term capital gain. In addition, the
federal tax status of each year's distributions generally will be reported to
the IRS. Distributions may also be subject to additional state, local, and
foreign taxes depending on a stockholder's particular situation. The Company's
ordinary income dividends to its corporate shareholders may, if certain
conditions are met, qualify for the dividends received deduction to the extent
that the Company has received qualifying dividend income during the taxable
year; capital gain dividends distributed by the Company are not eligible for the
dividends received deduction.

Non-U.S. Stockholders. A Stockholder that is not a U.S. Stockholder (a
"Non-U.S. Stockholder") generally is subject to withholding of United States
federal income tax at a 30% rate (or lower applicable treaty rate) on dividends
from the Company (other than capital gain dividends) that are not "effectively
connected" with a United States trade or business carried on by such
stockholder. Accordingly, investment in the Company is likely to be appropriate
for a Non-U.S. Stockholder only if such person can utilize a foreign tax credit
or corresponding tax benefit in respect of such United States withholding tax.

Non-effectively connected capital gain dividends and gains realized from
the sale of stock will not be subject to United States federal income tax in the
case of (i) a Non-U.S. Stockholder that is a corporation and (ii) a Non-U.S.
Stockholder that is not present in the United States for more than 182 days
during the taxable year (assuming that certain other conditions are met).
However, certain Non-U.S. Stockholders may nonetheless be subject to backup
withholding on capital gain dividends and gross proceeds paid to them upon the
sale of their stock. See "Backup Withholding" below.

If income from the Company or gains realized from the sale of stock is
effectively connected with a Non-U.S. Stockholder's United States trade or
business, then such amounts will be subject to United States federal income tax
at the tax rates applicable to United States persons. Non-U.S.

B-11
<PAGE> 120

Stockholders that are corporations may be also subject to an additional "branch
profits tax" with respect to income from the Company that is effectively
connected with a United States trade or business.

The United States Treasury Department recently issued Treasury regulations
generally effective for payments made after December 31, 1999 concerning the
withholding of tax and information reporting for certain amounts paid to
nonresident alien individuals and foreign corporations (the "Final Withholding
Regulations"). Among other things, the Final Withholding Regulations may require
Non-U.S. Stockholders to furnish new certification of their foreign status not
later than December 31, 1999. Prospective investors should consult their tax
advisors concerning the applicability and effect of the Final Withholding
Regulations on an investment in stock.

The tax consequences to a Non-U.S. Stockholder entitled to claim the
benefits of an applicable tax treaty may be different from those described in
this section. An applicable tax treaty may reduce the rate or the scope of U.S.
taxation imposed on the income of an eligible Non-U.S. Stockholder. Non-U.S.
Stockholders may be required to provide appropriate documentation to establish
their entitlement to the benefits of such a treaty. Foreign investors are
advised to consult their tax advisors with respect to the tax implications of
purchasing, holding and disposing of stock.

Backup Withholding. The Company may be required to withhold United States
federal income tax at a rate of 31% ("backup withholding") from dividends and
redemption proceeds paid to non-corporate stockholders. This tax may be withheld
from dividends if (i) the stockholder fails to furnish the Company with its
correct taxpayer identification number, (ii) the IRS notifies the Company that
the stockholder has failed to properly report certain interest and dividend
income to the IRS and to respond to notices to that effect or (iii) when
required to do so, the stockholder fails to certify that he or she is not
subject to backup withholding. Redemption proceeds may be subject to withholding
under the circumstances described in (i) above.

The Company may be required to report annually to the IRS and to each
Non-U.S. Stockholder the amount of dividends paid to such stockholder and the
amount, if any, of tax withheld pursuant to the backup withholding rules with
respect to such dividends. This information may also be made available to the
tax authorities in the Non-U.S. Stockholder's country of residence.

Backup withholding is not an additional tax. Any amounts withheld under the
backup withholding rules from payments made to a stockholder may be refunded or
credited against such stockholder's United States federal income tax liability,
if any, provided that the required information is furnished to the IRS.

YOU SHOULD CONSULT YOUR OWN TAX ADVISOR WITH RESPECT TO THE PARTICULAR TAX
CONSEQUENCES TO THEM OF AN INVESTMENT IN THE COMPANY, INCLUDING THE POSSIBLE
EFFECT OF ANY PENDING LEGISLATION OR PROPOSED REGULATION.

B-12
<PAGE> 121

PART C

INFORMATION NOT REQUIRED IN PROSPECTUS

ITEM 24. FINANCIAL STATEMENTS AND EXHIBITS

1. FINANCIAL STATEMENTS.

The following financial statements of Allied Capital Corporation (the
"Company" or the "Registrant") are included in this registration statement in
"Part A: Information Required in a Prospectus":

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Consolidated Balance Sheet -- March 31, 1999 (unaudited) and
December 31, 1998 and 1997................................ F-1
Consolidated Statement of Operations -- For the Three Months
Ended March 31, 1999 and 1998 (unaudited) and for the
Years Ended December 31, 1998, 1997 and 1996.............. F-2
Consolidated Statement of Changes in Net Assets -- For the
Three Months Ended March 31, 1999 and 1998 (unaudited) and
For the Years Ended December 31, 1998, 1997 and 1996...... F-3
Consolidated Statement of Cash Flows -- For the Three Months
Ended March 31, 1999 and 1998 (unaudited) and for the
Years Ended December 31, 1998, 1997 and 1996.............. F-4
Consolidated Statement of Investments -- March 31, 1999
(unaudited) and December 31, 1998......................... F-5
Notes to Consolidated Financial Statements.................. F-10
Report of Independent Public Accountants.................... F-31
</TABLE>

2. EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
a.1(1) Articles of Amendment and Restatement of the Articles of
Incorporation.
a.2(2) Articles of Merger.
b.(3) Bylaws.
c. Not applicable.
d.(6) Specimen certificate of the Company's Common Stock, par
value $0.0001, the rights of holders of which are defined in
Exhibits a.1, a.2 and b.
e.(3) Dividend Reinvestment Plan.
f.1(4) Form of debenture between certain subsidiaries of ACC and
the U.S. Small Business Administration.
f.2+ Credit Agreement dated as of March 9, 1999 between the
Company, as borrower, each of the financial institutions
initially a signatory thereto, as Lenders, and Nationsbank,
N.A., as administrative agent, Nationsbanc Montgomery
Securities LLC, as sole lead arranger and sole book manager,
First Union National Bank, as syndication agent, BankBoston,
N.A., as documentation agent, Riggs Bank, N.A., as managing
agent, and Chevy Chase Bank, F.S.B. and Credit Lyonnais New
York Branch, as co-agents.
f.3(7) Note Agreement dated as of April 30, 1998.
f.4(5) Loan Agreement between Allied I and Overseas Private
Investment Corporation, dated April 10, 1995. Letter dated
December 11, 1997 evidencing assignment of Loan Agreement
from Allied I to the Company.
f.6(8) Amended and Restated Master Loan & Security Agreement dated
October 7, 1998 among the Company, BMI and Morgan Stanley
Mortgage Capital, Inc.
f.7.a(6) Sale and Servicing Agreement dated, as of January 1, 1998,
among Allied Capital CMT, Inc., Allied Capital Commercial
Mortgage Trust 1998-1 and Allied Capital Corporation and
LaSalle National Bank and ABN AMRO Bank N.V.
</TABLE>

C-1
<PAGE> 122

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
f.7.b(6) Indenture dated as of January 1, 1998, between the Allied
Capital Commercial Mortgage Trust 1998-1 and LaSalle
National Bank.
f.7.c(6) Amended and Restated Trust Agreement, dated January 1, 1998
between Allied Capital CMT, LaSalle National Bank Inc. and
Wilmington Trust Company.
f.7.d(6) Guaranty dated as of January 1, 1998 by the Company.
g. Not applicable.
h.1+ Form of Underwriting Agreement, if applicable.
i.1(3) Employee Stock Ownership Plan, as amended on December 31,
1997.
i.1a(7) First Amendment to the Allied Capital Corporation Employee
Stock Ownership Plan dated April 30, 1998.
i.2(10) Amended and Restated Deferred Compensation Plan dated
December 30, 1998.
i.3(9) Stock Option Plan.
i.4 Description of Formula Award and Cut-Off Award Arrangements.
A discussion of the Formula and Cut-off Awards is set forth
on pages 54 and 56 of the Prospectus to the Registration
Statement and pages B-4 through B-6 of the SAI.
j.1(6) Form of Custody Agreement with Riggs Bank N.A. with respect
to safekeeping.
j.2(6) Form of Custody Agreement with LaSalle National Bank.
l.+ Opinion of counsel and consent to its use.
m. Not applicable.
n.1* Consent of Arthur Andersen LLP, independent public
accountants.
n.2* Consent of Sutherland, Asbill & Brennan LLP.
o. Not applicable.
p. Not applicable.
q. Not applicable.
r.* Financial Data Schedule.
</TABLE>

- -------------------------

<TABLE>
<C> <S>
* Filed herewith.
+ Filed previously with this Registration Statement on Form
N-2 (File No. 333-75161)
(1) Incorporated by reference to exhibit 3(i) filed with Allied
Lending's Annual Report on Form 10-K for the year ended
December 31, 1996.
(2) Incorporated by reference from Appendix B to the Company's
registration statement on Form N-14 filed on September 26,
1997 (File No. 333-36459).
(3) Incorporated by reference to the exhibit of the same name
filed with the Company's Annual Report on Form 10-K for the
year ended December 31, 1997.
(4) Incorporated by reference to the exhibit of the same name
filed with Allied I's Annual Report on Form 10-K for the
year ended December 31, 1996.
(5) Incorporated by reference to the exhibit f.7 filed with
Allied I's Pre-Effective Amendment No. 2 to the registration
statement on Form N-2 on January 24, 1996 (File No.
33-64629). Assignment to the Company is incorporated by
reference to Exhibit 10.3 of the Company's Annual Report on
Form 10-K for the year ended December 31, 1997.
(6) Incorporated by reference to the exhibit of the same name to
the Company's registration statement on Form N-2 filed on
the Company's behalf with the Commission on May 5, 1998
(File No. 333-51899).
(7) Incorporated by reference to the exhibit of same name filed
with the Company's Quarterly Report on Form 10-Q for the
period ended June 30, 1998.
(8) Incorporated by reference to the exhibit of the same name
filed with the Company's Quarterly Report on Form 10-Q for
the period ended September 30, 1998.
(9) Incorporated by reference to Exhibit 4 of the Allied Capital
Corporation Stock Option Plan registration statement on Form
S-8, filed on behalf of such Plan on February 3, 1998 (File
No. 333-45525).
(10) Incorporated by reference to the exhibit of the same name
filed with the Company's Annual Report on Form 10-K for the
year ended December 31, 1998.
</TABLE>

C-2
<PAGE> 123

ITEM 25. MARKETING ARRANGEMENTS

The information contained under the heading "Plan of Distribution" on page
65 of the prospectus is incorporated herein by reference, and any information
concerning any underwriters will be contained in the accompanying prospectus
supplement, if any.

ITEM 26. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION

<TABLE>
<S> <C>
Commission registration fee*................................ $ 28,902
NASD filing fee*............................................ $ 10,896
Nasdaq National Market Additional Listing Fee*.............. $ 17,500
Accounting fees and expenses................................ $100,000
Legal fees and expenses..................................... $300,000
Printing and engraving...................................... $250,000
Miscellaneous fees and expenses............................. $ 2,702
--------
Total.................................................. $710,000
========
</TABLE>

- -------------------------
* Estimated for filing purposes.

All of the expenses set forth above shall be borne by the Company.

ITEM 27. PERSONS CONTROLLED BY OR UNDER COMMON CONTROL

Direct Subsidiaries

The following list sets forth each of the Company's subsidiaries, the state
or country under whose laws the subsidiary is organized, and the percentage of
voting securities or membership interests owned by the Company in such
subsidiary:

<TABLE>
<S> <C>
Allied Investment Corporation (Maryland).................... 100%
Allied Capital SBLC Corporation (Maryland).................. 100%
Allied Capital REIT, Inc. ("Allied REIT") (Maryland)........ 100%
Allied Capital Holdings LLC (Delaware)...................... 100%
PC Acquisition Corporation (Maryland)....................... 100%
Allied Capital Beteiligungsberatung GmbH (Germany).......... 100%
</TABLE>

Each of the Company's subsidiaries are consolidated with the Company for
financial reporting purposes, except as noted below.

Indirect Subsidiaries

The Company indirectly controls the entities set forth below through Allied
REIT. Allied REIT owns either all of the membership interests (in the case of a
limited liability company, "LLC") or all of the outstanding voting stock (in the
case of a corporation) of each entity. The following list sets forth each of
Allied REIT's subsidiaries, the state under whose laws the subsidiary is
organized, and the percentage of voting securities or membership interests owned
by Allied REIT of such subsidiary:

<TABLE>
<S> <C>
Allied Capital Property LLC (Delaware)...................... 100%
Allied Capital Equity LLC (Delaware)........................ 100%
9586 I-25 East Frontage Road, Longmont, CO 80504 LLC
(Delaware)................................................ 100%
8930 Stanford Boulevard LLC (Delaware)...................... 100%
Allied Capital CMT, Inc. (Delaware)......................... 100%
</TABLE>

Allied REIT also indirectly owns Allied Capital Commercial Mortgage Trust
1998-1, a Delaware business trust that is wholly owned by Allied Capital CMT,
Inc. ("CMT"). Each subsidiary of Allied

C-3
<PAGE> 124

REIT and CMT is not required to maintain financial and other reports required
under the Securities Act because each does not have a class of securities
registered under the Securities Act.

The Company indirectly controls Allied Capital SBLC Holdings LLC (Delaware)
through Allied Capital SBLC Corporation, which owns 100% of the membership
interests. The Company indirectly controls Allied Investment Holdings LLC
(Delaware) through Allied Investment Corporation, which owns 100% of the
membership interests.

Other Entities Deemed to be Controlled by the Company

The Company provides investment advisory services to the certain entities
and therefore may be deemed to control such entities and their respective
subsidiaries. The following list sets forth each such entity and its respective
subsidiaries and the state under whose laws the entity or subsidiary is
organized:

Allied Capital Germany Fund LLC (Delaware)(1, 2)

Allied Capital Syndication LLC (Delaware)(2)

Business Mortgage Investors, Inc. (Maryland)(1)
Wholly owned subsidiaries of Business Mortgage Investors, Inc.:
BMI Holdings, Inc. (Maryland)
BMI Funding, Inc. (Delaware)
Indirect subsidiary of Business Mortgage Investors, Inc.
BMI Funding LLC (Delaware), of which BMI Funding, Inc. owns substantially
all membership interests

The Company has also established certain limited purpose entities in order to
facilitate certain portfolio transactions.
- -------------------------
(1) By so including these entities herein, the Registrant does not concede that
it controls such entities.

(2) Subsidiary does not consolidate for financial reporting purposes.

ITEM 28. NUMBER OF HOLDERS OF SECURITIES

The following table sets forth the approximate number of record holders of
the Company's Common Stock at April 30, 1999.

<TABLE>
<CAPTION>
NUMBER OF
TITLE OF CLASS RECORD HOLDERS
-------------- --------------
<S> <C>
Common Stock, $0.0001 par value........................... 4,500
</TABLE>

ITEM 29. INDEMNIFICATION

The Annotated Code of Maryland, Corporations and Associations (the
"Maryland Law"), Section 2-418 provides that a Maryland corporation may
indemnify any director of the corporation and any person who, while a director
of the corporation, is or was serving at the request of the corporation as a
director, officer, partner, trustee, employee, or agent of another foreign or
domestic corporation, partnership, joint venture, trust, other enterprise or
employee benefit plan, made a party to any proceeding by reason of service in
that capacity unless it is established that the act or omission of the director
was material to the matter giving rise to the proceeding and was committed in
bad faith or was the result of active and deliberate dishonesty; or the director
actually received an improper personal benefit in money, property or services;
or, in the case of any criminal proceeding, the director had reasonable cause to
believe that the act or omission was unlawful. Indemnification may be made
against judgments, penalties, fines, settlements, and reasonable expenses
actually

C-4
<PAGE> 125

incurred by the director in connection with the proceeding, but if the
proceeding was one by or in the right of the corporation, indemnification may
not be made in respect of any proceeding in which the director shall have been
adjudged to be liable to the corporation. Such indemnification may not be made
unless authorized for a specific proceeding after a determination has been made,
in the manner prescribed by the law, that indemnification is permissible in the
circumstances because the director has met the applicable standard of conduct.
On the other hand, the director must be indemnified for expenses if he or she
has been successful in the defense of the proceeding or as otherwise ordered by
a court. The law also prescribes the circumstances under which the corporation
may advance expenses to, or obtain insurance or similar cover for, directors.

The law also provides for comparable indemnification for corporate officers
and agents.

The Articles of Incorporation of the Company provide that its directors and
officers shall, and its agents in the discretion of the board of directors may,
be indemnified to the fullest extent permitted from time to time by the laws of
Maryland (with such power to indemnify officers and directors limited to the
scope provided for in Section 2-418 as currently in force). The Company's
Bylaws, however, provide that the Company may not indemnify any director or
officer against liability to the Company or its security holders to which he or
she might otherwise be subject by reason of such person's willful misfeasance,
bad faith, gross negligence or reckless disregard of the duties involved in the
conduct of his or her office unless a determination is made by final decision of
a court, by vote of a majority of a quorum of directors who are disinterested,
non-party directors or by independent legal counsel that the liability for which
indemnification is sought did not arise out of such disabling conduct.

Insofar as indemnification for liabilities arising under the Securities Act
of 1933 may be permitted to directors, officers and controlling persons of the
Company pursuant to the provisions described above, or otherwise, the Company
has been advised that in the opinion of the Securities and Exchange Commission
such indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable. In the event that a claim for indemnification against
such liabilities (other than the payment by the Company of expenses incurred or
paid by a director, officer or controlling person in the successful defense of
an action, suit or proceeding) is asserted by a director, officer or controlling
person in connection with the securities being registered, the Company will,
unless in the opinion of its counsel the matter has been settled by controlling
precedent, submit to a court of appropriate jurisdiction the question whether
such indemnification by it is against public policy as expressed in the Act and
will be governed by the final adjudication of the court of the issue.

The Company carries liability insurance for the benefit of its directors
and officers on a claims-made basis of up to $5,000,000, subject to a $250,000
retention and the other terms thereof.

The Agreement and Plan of Merger (the "Merger Agreement") by and among
Advisers, Allied I, Allied II, Allied Lending and Allied Commercial provides
that, from and after consummation of the Merger the Company shall indemnify any
person who at the date of the Merger Agreement, or had been at any time prior to
such date or who becomes prior to the effective time of the merger, an officer
or director of Allied I, Allied II, Allied Commercial or Advisers, or any of
their respective subsidiaries, from any and all liabilities resulting from their
acts and omissions prior to the effective time of the merger to the full extent
permitted by Maryland Law and the 1940 Act, including but not limited to acts
and omissions arising out of or pertaining to the merger, and shall maintain in
effect for at least 72 months directors' and officers' liability insurance
policies with respect to matters occurring prior to the effective time of the
merger.

ITEM 30. BUSINESS AND OTHER CONNECTIONS OF INVESTMENT ADVISER

Not applicable.

C-5
<PAGE> 126

ITEM 31. LOCATION OF ACCOUNTS AND RECORDS

The Company maintains at its principal office physical possession of each
account, book or other document required to be maintained by Section 31(a) of
the 1940 Act and the rules thereunder.

ITEM 32. MANAGEMENT SERVICES

Not applicable.

ITEM 33. UNDERTAKINGS

The Registrant hereby undertakes:

(1) to suspend the offering of shares until the prospectus is amended
if subsequent to the effective date of this Registration Statement, its net
asset value declines more than ten percent from its net asset value as of
the effective date of this Registration Statement;

(2) to file, during any period in which offers or sales are being
made, a post-effective amendment to this registration statement:

(i) to include any prospectus required by Section 10(a)(3) of the
Securities Act of 1933;

(ii) to reflect in the prospectus any facts or events arising
after the effective date of the registration statement (or
the most recent post-effective amendment thereof) which,
individually or in the aggregate, represent a fundamental
change in the information set forth in the registration
statement. Notwithstanding the foregoing, any increase or
decrease in volume of securities offered (if the total
dollar value of securities offered would not exceed that
which was registered) and any deviation from the low or high
end of the estimated maximum offering range may be reflected
in the form of prospectus filed with the Commission pursuant
to Rule 424(b) under the Securities Act of 1933 if, in the
aggregate, the changes in volume and price represent no more
than a 20% change in the maximum aggregate offering price
set forth in the "Calculation of Registration Fee" table in
the effective registration statement; and

(iii) to include any material information with respect to the plan
of distribution not previously disclosed in the registration
statement or any material change to such information in the
registration statement.

(3) that, for the purpose of determining any liability under the
Securities Act of 1933, the information omitted from the form of prospectus
filed as part of this Registration Statement in reliance upon Rule 430A and
contained in a form of prospectus filed by the Registrant under Rule 497(h)
under the Securities Act of 1933 shall be deemed to be part of this
Registration Statement as of the time it was declared effective;

(4) to remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering;

(5) that, for the purpose of determining any liability under the
Securities Act of 1933, each post effective amendment that contains a form
of prospectus shall be deemed to be a new registration statement relating
to the securities offered therein, and the offering of the securities at
that time shall be deemed to be the initial bona fide offering thereof; and

(6) to send by first class mail or other means designed to ensure
equally prompt delivery, within two business days of receipt of a written
or oral request, any Statement of Additional Information.

C-6
<PAGE> 127

Subject to the terms and conditions of Section 15(d) of the Securities
Exchange Act of 1934, the registrant hereby undertakes to file with the
Securities and Exchange Commission such supplementary and periodic information,
documents and reports as may be prescribed by any rule or regulation of the
Commission heretofore or hereafter duly adopted pursuant to authority conferred
in that section.

Insofar as indemnification for liability arising under the Securities Act
may be permitted to directors, officers and controlling persons of the
registrant pursuant to the provisions of its charter and bylaws permitting
indemnification, or otherwise, the registrant has been advised that in the
opinion of the Commission such indemnification is against public policy as
expressed in the Securities Act and is, therefore unenforceable. In the event
that a claim for indemnification against such liabilities (other than the
payment by the registrant of expenses incurred or paid by a director, officer or
controlling person of the registrant in the successful defense of any action,
suit or proceeding) is asserted by such director, officer or controlling person
in connection with the securities being registered, the registrant will, unless
in the opinion of its counsel the matter has been settled by controlling
precedent, submit to a court of appropriate jurisdiction the question whether
such indemnification by it is against public policy as expressed in the
Securities Act and will be governed by the final adjudication of such issue.

C-7
<PAGE> 128

SIGNATURES

Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this registration statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Washington, in the
District of Columbia, on the 6th day of May, 1999.

ALLIED CAPITAL CORPORATION

By: /s/ William L. Walton

----------------------------------------
William L. Walton
Chief Executive Officer and
President

Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed by the following persons in the
capacities indicated on May 6, 1999.

<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<C> <S>

/s/ William L. Walton Chairman of the Board, Chief Executive Officer, and
- --------------------------------------------- President
William L. Walton

* Director
- ---------------------------------------------
Brooks H. Browne

* Director
- ---------------------------------------------
John D. Firestone

* Director
- ---------------------------------------------
Anthony T. Garcia

* Director
- ---------------------------------------------
Lawrence I. Hebert

* Director
- ---------------------------------------------
John I. Leahy

* Director
- ---------------------------------------------
Robert E. Long

* Director
- ---------------------------------------------
Warren K. Montouri

* Director
- ---------------------------------------------
Guy T. Steuart II

* Director
- ---------------------------------------------
T. Murray Toomey

* Director
- ---------------------------------------------
Laura W. van Roijen
</TABLE>
<PAGE> 129

<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<C> <S>
* Director
- ---------------------------------------------
George C. Williams

/s/ Penni F. Roll Principal and Chief Financial Officer (Principal
- --------------------------------------------- Financial and Accounting Officer)
Penni F. Roll
</TABLE>

* Signed by William L. Walton pursuant to a power-of-attorney signed by the
individual and filed with this registration statement on March 26, 1999.

<PAGE> 130

INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- --------------- -----------
<S> <C>
Ex - 99.2n.1 Consent of Arthur Andersen LLP, independent public
accountants.
Ex - 99.2n.2 Consent of counsel
Ex - 99.2r Financial Data Schedule
</TABLE>

<PAGE> 1
EXHIBIT EX-99.2n.1

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the use of our report
dated February 18, 1999, and to all references to our firm included in this
registration statement.

/s/ Arthur Andersen LLP

Vienna, Virginia
May 6, 1999

<PAGE> 1
[Sutherland Asbill & Brennan LLP] EXHIBIT EX-99.2n.2

CONSENT OF SUTHERLAND ASBILL & BRENNAN LLP

We hereby consent to the reference to our firm in the "Legal Matters"
section of the prospectus included in the Pre-Effective Amendment No. 1 to the
Registration Statement on Form N-2 for Allied Capital Corporation (File No.
333-75161). In giving this consent, we do not admit that we are in the category
of persons whose consent is required under Section 7 of the Securities Act of
1933, as amended.

SUTHERLAND ASBILL & BRENNAN LLP

May 6, 1999 By: /s / Steven B. Boehm
--------------------------------

Steven B. Boehm

<ARTICLE> 6
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM ALLIED
CAPITAL CORPORATION AND SUBSIDIARIES' CONSOLIDATED BALANCE SHEET AND
CONSOLIDATED STATEMENTS OF OPERATIONS, CHANGES IN NET ASSETS AND CASH FLOWS AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS
INCORPORATED BY REFERENCE IN FORM N-2.
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<INVESTMENTS-AT-COST> 796,389
<INVESTMENTS-AT-VALUE> 800,274
<RECEIVABLES> 0
<ASSETS-OTHER> 30,730
<OTHER-ITEMS-ASSETS> 25,075
<TOTAL-ASSETS> 856,079
<PAYABLE-FOR-SECURITIES> 0
<SENIOR-LONG-TERM-DEBT> 239,350
<OTHER-ITEMS-LIABILITIES> 124,612
<TOTAL-LIABILITIES> 363,962
<SENIOR-EQUITY> 6
<PAID-IN-CAPITAL-COMMON> 526,824
<SHARES-COMMON-STOCK> 55,919
<SHARES-COMMON-PRIOR> 52,047
<ACCUMULATED-NII-CURRENT> (927)
<OVERDISTRIBUTION-NII> 0
<ACCUMULATED-NET-GAINS> 0
<OVERDISTRIBUTION-GAINS> 0
<ACCUM-APPREC-OR-DEPREC> 2,380
<NET-ASSETS> 485,117
<DIVIDEND-INCOME> 0
<INTEREST-INCOME> 79,921
<OTHER-INCOME> 26,817
<EXPENSES-NET> 51,493
<NET-INVESTMENT-INCOME> 55,245
<REALIZED-GAINS-CURRENT> 22,541
<APPREC-INCREASE-CURRENT> 1,079
<NET-CHANGE-FROM-OPS> 78,078
<EQUALIZATION> 0
<DISTRIBUTIONS-OF-INCOME> 49,627
<DISTRIBUTIONS-OF-GAINS> 25,690
<DISTRIBUTIONS-OTHER> 0
<NUMBER-OF-SHARES-SOLD> 4,374
<NUMBER-OF-SHARES-REDEEMED> 810
<SHARES-REINVESTED> 241
<NET-CHANGE-IN-ASSETS> 65,057
<ACCUMULATED-NII-PRIOR> 0
<ACCUMULATED-GAINS-PRIOR> 0
<OVERDISTRIB-NII-PRIOR> 2,679
<OVERDIST-NET-GAINS-PRIOR> 0
<GROSS-ADVISORY-FEES> 3,123
<INTEREST-EXPENSE> 20,694
<GROSS-EXPENSE> 51,493
<AVERAGE-NET-ASSETS> 452,588
<PER-SHARE-NAV-BEGIN> 8.07
<PER-SHARE-NII> 1.06
<PER-SHARE-GAIN-APPREC> 0.45
<PER-SHARE-DIVIDEND> 1.43
<PER-SHARE-DISTRIBUTIONS> 0.00
<RETURNS-OF-CAPITAL> 0.00
<PER-SHARE-NAV-END> 8.68
<EXPENSE-RATIO> 0.11
<AVG-DEBT-OUTSTANDING> 372,388
<AVG-DEBT-PER-SHARE> 7.16

</TABLE>