UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

For the fiscal year ended December 31, 2003

Commission File No. 1-31753

CapitalSource Inc.

Securities Registered Pursuant to Section 12(g) of the Act:

      Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

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

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

      As of March 1, 2004, the number of shares of the Registrant’s Common Stock, par value $.01 per share, outstanding was 118,817,918.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of CapitalSource Inc.’s Proxy Statement for the 2004 annual meeting of shareholders, a definitive copy of which will be filed with the SEC within 120 days after the end of the year covered by this Form 10-K, are incorporated by reference herein as portions of Part III of this Form 10-K.

TABLE OF CONTENTS

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PART I

      This Form 10-K contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Our actual results could differ materially from those set forth in each forward-looking statement. Certain factors that might cause such a difference are discussed in this report, including in the section entitled “Forward-Looking Statements and Projections” on page 26 and in the section entitled “Risk Factors” on page 46 of this Form 10-K.

ITEM 1.     BUSINESS

      We are a specialized commercial finance company providing loans to small and medium-sized businesses. Our goal is to be the lender of choice for businesses with $5 million to $250 million in annual revenues that require customized and sophisticated debt financing. We provide a wide range of debt financing products that we negotiate and structure on a client-specific basis, through direct interaction with the owners and senior managers of our clients. We seek to add value to our clients’ businesses by providing tailored debt financing that meets their specific business needs and objectives.

      Since our inception in September 2000 through December 31, 2003, we have made 504 loans representing an aggregate of $4.8 billion of committed capital. As of December 31, 2003, we had $2.4 billion in loans outstanding and commitments to lend up to an additional $1.3 billion to our clients. As of December 31, 2003, we had 285 employees.

      The financing needs of our clients are often specific to their particular businesses or their particular situation. We believe we can most successfully meet these needs and manage risk through industry or sector focus and flexibility in structuring financings. Because we believe a narrow focus is important to successfully serve our client base, we originate, underwrite and manage our loans through three focused lending groups organized around our areas of expertise. Focusing our efforts in these specific sectors, industries and markets allows us to rapidly design and implement lending products that satisfy the special financing needs of our clients. Our lending groups are:

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

      We price our loans based upon the risk profile of our clients. Our loans generally range in size from $1 million to $50 million, mature in two to five years, and require monthly interest payments at floating interest rates. Senior secured asset-based loans comprised approximately 33% of our portfolio as of December 31, 2003. Senior secured cash flow and first mortgage loans made up an additional 35% and 28%, respectively, and mezzanine loans accounted for 4% of our portfolio as of December 31, 2003. As of December 31, 2003, our geographically diverse client base consisted of approximately 311 clients with headquarters in 39 states and Washington, D.C.

Our Lending Groups

      The following describes the particular characteristics of our three focused lending groups: Corporate Finance, HealthCare Finance and Structured Finance.

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      Our Corporate Finance group provides debt financing to small and medium-sized businesses typically sponsored by private equity firms, most often in connection with extraordinary corporate transactions such as leveraged buyouts. We consider small to medium-sized private equity firms to be our primary clients and consider the provision of debt financing in connection with leveraged buyouts with a transaction size of between $15 million and $100 million to be our primary market opportunity.

      We finance a wide variety of companies, including:

	•	business services companies;
	•	consumer products and brands;
	•	value-added manufacturers;
	•	media companies, primarily television and radio broadcasters;
	•	retailers; and
	•	healthcare service companies operating in non-reimbursement sectors.

      Corporate Finance finances fundamentally sound businesses at a significant discount to their enterprise value. In particular, we focus on companies with experienced management teams that have market leadership positions in attractive niches or where significant barriers to entry or “switching costs,” that is, the expenses incurred by customers of our borrowers to find new suppliers/service providers, exist. Leveraging off the asset-based and structuring capabilities that reside within our company, we can also provide a variety of highly structured financings. These financings are often used by our clients to provide added liquidity in a turnaround, satisfy off balance sheet financing needs to otherwise fund a special situation or transaction.

      In almost all cases, we source our transactions either through private equity investors who acquire businesses for financial or strategic purposes or through financial intermediaries such as accounting, law, investment banking, brokerage, or turnaround consulting firms. We have relationships with many of the country’s leading private equity sponsors, and we believe that we have developed a reputation among these firms and other professionals for our ability to quickly assess a situation and offer a creative and timely response.

      Through our existing relationships and by developing additional strategic relationships with private equity firms, we believe we will be able to continue to grow our Corporate Finance loan portfolio. Private equity funds generally invest significant amounts of equity in their portfolio companies only after performing significant amounts of due diligence and analysis. In addition, due to the magnitude of their typical investments, private equity firms are motivated to manage their investments closely.

      We provide cash flow and asset-based financings, generally ranging from $5 million to $50 million, for:

	•	acquisitions;
	•	leveraged buyouts;
	•	consolidations;
	•	recapitalizations; and
	•	corporate growth.

      Our financing transactions are generally structured as:

	•	senior secured term debt underwritten to cash flow;
	•	senior secured asset-based revolving loans; or
	•	mezzanine debt, typically in the form of junior or senior subordinated term debt, generally also involving warrants in the client’s equity.

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      We often provide both senior and mezzanine debt to a single client to provide all or substantially all the debt financing for a transaction. We also often provide an asset-based revolver in connection with our senior term loans. Additionally, we often make small equity investments in our clients.

      As of December 31, 2003, Corporate Finance had $972 million in loans outstanding as well as commitments to loan an additional $341 million to 67 existing clients.

      Our HealthCare Finance group generally provides accounts receivable-based, short-term real estate, equipment and other financing to small and medium-sized businesses in the healthcare market, the largest segment of the U.S. economy. The healthcare industry is dominated by small to medium-sized businesses and exhibits rapid growth, consolidation and change.

      We believe that there are several distinct drivers of this growth, including:

	•	growth in private and public spending on healthcare and a rising percentage of the U.S. gross domestic product devoted to healthcare;
	•	governmental and market forces which have put pressure on healthcare service providers to reduce healthcare delivery costs and increase efficiency, producing short-term capital needs as providers increasingly are forced to rely on new technologies to enable their businesses to grow;
	•	favorable demographic trends, including both the increase in and aging of the U.S. population;
	•	growth, consolidation, and restructuring of fragmented sub-markets in healthcare, including long-term care, hospitals and physician practices; and
	•	advances in medical technology, which have increased demand for healthcare services by increasing the number of diseases that can be effectively treated and by extending the population’s life expectancy.

      We have specifically targeted the debt financing needs of the following healthcare sub-markets:

	•	skilled nursing providers;
	•	acute care and long-term acute care hospitals;
	•	mental health providers; and
	•	home healthcare providers.

      Despite what we perceive as a likelihood of significant opportunities due to the potential for growth, consolidation and restructurings in these sub-markets, companies operating in these highly fragmented sub-markets often have significant financing needs that go unmet by traditional sources. While some commercial banks and diversified finance companies have divisions that provide financing for healthcare service providers, these lenders generally lend only to companies with borrowing needs in excess of $20 million and often require that clients have an extensive operating history.

      The clients of our HealthCare Finance group often derive a significant portion of their revenues from third-party reimbursements, particularly Medicare and Medicaid. We provide a broad range of asset-based and cash flow floating-rate financing products in connection with acquisitions, refinancings and recapitalizations, as well as for general operations.

      We primarily finance smaller, growing companies with limited access to sources of financing. Some of our clients are constrained from obtaining financing from more traditional sources due to their inadequate equity capitalization, limited operating history, lack of profitability or because their financing needs fall below commercial bank size requirements. We believe that we have the healthcare industry expertise needed to underwrite smaller healthcare service companies and the specialized systems necessary for tracking and monitoring healthcare receivables transactions.

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      Our financing activities are generally structured as:

	•	senior term loans secured by a first mortgage in the healthcare facility;
	•	asset-based loans secured by an interest in the client’s assets, including in most instances accounts receivable; and
	•	senior secured and mezzanine loans underwritten to cash flow of clients owning healthcare facilities or providing healthcare services.

      As of December 31, 2003, HealthCare Finance had $657 million in loans outstanding as well as commitments to loan an additional $520 million to 126 existing clients.

      Our Structured Finance group provides debt financing to small and medium-sized businesses that require complex financing alternatives within our targeted sectors of lender finance and real estate. Our product offerings vary depending on which of our target markets we are servicing. In our lender finance business, we make loans to finance companies. As collateral for our loans, these finance companies pledge to us their loans to their customers, which we refer to as receivables. In servicing the lender finance market, we offer clients senior term loans and revolving credit facilities. We target:

	•	specialized commercial lenders such as mortgage companies, leasing companies and asset-based lenders;
	•	specialized consumer lenders such as consumer installment lenders and automobile lenders; and
	•	resort developers and finance lenders.

      We also conduct a mortgage lending practice through Structured Finance. We make floating-rate term loans secured by various types of real estate, including office, industrial, hospitality, multi-family and residential properties. These loans may be structured either as senior loans or as mezzanine loans typically with terms of two to five years. The borrowers are usually special purpose entities that have been formed for the purpose of holding discrete properties by experienced owners and operators of real property. We generally make loans that do not fit bank or insurance company lending criteria.

      Our senior loans are secured by a first mortgage in the relevant property. Our mezzanine loans may be secured by a second mortgage on the relevant property or a direct or indirect pledge of equity in the entity that owns the property. Our credit philosophy for our real estate finance activities emphasizes selecting properties that generate stable or increasing cash flow streams, have strong asset quality, and proven sponsorship with defined business plans. Our senior loans are often used to fund acquisitions of properties that the new owner intends to use for a purpose that is different than what the property is being used for at the time of the purchase. This repositioning of the property often requires repayment flexibility. To address this need our mortgage loans may have little or no principal payment requirements for all or a portion of the loan term. We generally advance the client an amount up to 90% of the lesser of the appraised value or the actual cost of the property that secures the loan.

      As of December 31, 2003, Structured Finance had $788 million in loans outstanding as well as commitments to loan an additional $395 million to 118 existing clients.

Loan Products and Service Offerings

      The types of loan products and services offered by each of our lending groups share common characteristics, and we generally underwrite the same types of loans across our three groups using the same criteria. When opportunities arise, we may offer a combination of products to a particular client. This single source approach often allows us to close transactions faster than our competitors and avoids complicated and time-consuming intercreditor negotiations. We believe our flexibility in terms of the variety of our product and service offerings and our willingness to structure our loans to meet the particular needs of our clients provide us with a competitive advantage over other lenders.

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      Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable and/or inventory. A loan is a “senior” loan when we have a first priority lien in the collateral securing the loan. Consequently, in the event of a liquidation of the client, we would generally be entitled to the proceeds of the liquidation before the client’s other creditors. These loans, which are generally between $1 million and $50 million, usually have a term of two to five years. We generally will advance a client, on a revolving basis, between 80% and 90% of the value of the client’s eligible receivables or between 30% and 70% of a client’s eligible inventory.

      A client’s eligible receivables are those receivables that, in our assessment, will be collectible by the client within a specified period of time. In determining which of a client’s receivables are eligible receivables, we assess the client’s total receivables and make an adjustment for that portion of the total receivables we believe may be uncollectible. For instance, if a potential client has $20 million of accounts receivable on its balance sheet and we believe, based upon our due diligence, that 10% of these receivables may ultimately be uncollectible, in our view, the client has $18 million of eligible receivables to serve as collateral for our loan. We will consider lending the client up to 90% of that amount.

      A client’s eligible inventory is that portion of the client’s total inventory that we believe the client will be able to liquidate within a specified period of time. In determining which portion of a client’s inventory is eligible inventory, we assess the client’s total inventory and make a judgment as to the portion of the inventory that the client may not be able to sell. For instance, if a potential client has $20 million in inventory on hand and we believe that, based on our due diligence, the client may ultimately be unable to sell $2 million of that inventory, in our view, the client has $18 million of eligible inventory to serve as security for our loan. We will consider lending the client up to 70% of that amount.

      We believe that by using established advance rates against eligible collateral we guard against the deterioration of a client’s performance. Generally, we establish these advance rates assuming liquidation of the client’s assets, which is designed to assure repayment of our loan regardless of the client’s business prospects. As a result, in addition to our standard underwriting procedures performed on every client, we conduct extensive due diligence to develop an estimate of a prospective client’s eligible receivables or inventory to establish the correct advance rate when underwriting asset-based loans.

      We perform industry-specific procedures when assessing the eligibility of receivables in originating asset-based loans in our Structured Finance and HealthCare Finance groups. In underwriting the eligible receivables for the Structured Finance loans, we closely analyze the receivables portfolios against which we lend. This analysis includes scrutiny of the following characteristics:

	•	performance of the receivables, including an extensive analysis of a discrete pool of receivables over a specified period of time;
	•	seasoning, or the length of time that the receivables have been outstanding;
	•	adherence by the party that owes the receivable to our client to the terms of the contract that forms the basis for the receivable;
	•	credit score, such as FICO or FAIR, if applicable, of the parties that owe the receivables; and
	•	diversification of the client’s receivables portfolio that serves as collateral for our loan with a focus on:

	•	average receivables size;
	•	geographic distribution of the receivables;
	•	maturities of the receivables; and
	•	weighted average interest rate of the portfolio.

      In our HealthCare Finance group, we conduct targeted examinations of the client’s accounts receivables due from third-party payors. Most of these receivables are payment obligations of federal and state Medicare

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	•	a review of historical collections by type of third-party payor;
	•	a review of remittance advice and information relating to claim denials;
	•	a review of claims files;
	•	an analysis of billing and collections staff and procedures; and
	•	a comparison of net revenues to historical collections.

      We mitigate the risk of our senior asset-based loans by placing a first priority lien, typically on all of the client’s assets, not just the receivables and/or inventory deemed eligible for purposes of determining the borrowing base of the loan. We also generally cross-collateralize and cross-default our asset-based revolving credit facilities and term loans made to the same client. An asset-based revolving credit facility is a loan in which the client may borrow, repay and then reborrow money based on the value of its eligible collateral. Unlike a revolving loan, once the client repays any portion of its outstanding borrowings under a term loan, that portion is not available for reborrowing. If a client is, as many of our clients are, a borrower under both a senior term loan and an asset-based revolving credit facility, and were to default on its obligations under either loan, we could use the collateral pledged as security for either loan to satisfy any of the defaulted obligations.

      Notwithstanding these security arrangements, we assess the viability of the client’s business to determine whether the client can sustain its business operations for the duration of the loan. For further security in our collection efforts, we typically require that a client’s cash receipts be deposited in a lockbox account that remains under our control for as long as any portion of the loan is outstanding. Funds from the lockbox account are generally automatically swept into our account on a periodic basis to satisfy the client’s loan obligations to us. In some instances, as additional security on our loans, we will also require a guarantee from, or enter into a capital call agreement with, one or more of a client’s equity sponsors. A typical guarantee requires the equity sponsor to satisfy all or a portion of the client’s obligations to us if the client defaults on its obligations. Under a typical capital call arrangement, we have the ability to require a client’s equity sponsor to provide additional funds to the client so that the client may satisfy its debt to us. In addition, in most of our financings to other lenders we also engage independent third parties as collateral custodians to hold and maintain the documentation representing our collateral.

      Our asset-based loans typically contain financial covenants that require the client to, among other things, maintain a minimum net worth and fixed charge coverage throughout the life of the loan.

      We make loans based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan. These types of loans are referred to as cash flow loans. Our senior cash flow term loans generally are secured by a security interest in all or substantially all of a client’s current and fixed assets. In some cases, the equity owners of a client pledge their stock in the client to us. These loans generally range in size from $1 million to $40 million and have a term of three to five years.

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      In determining whether we believe a client will be able to generate sufficient cash flow to repay the loan, we consider a variety of factors including the client’s:

	•	historical and projected profitability;
	•	balance sheet strength and liquidity;
	•	equity sponsorship;
	•	market position;
	•	management strength and experience;
	•	proprietary nature of the business, if applicable;
	•	ability to withstand competitive challenges; and
	•	relationships with clients and suppliers.

      Clients who borrow under our cash flow loans are typically subject to a number of financial covenants for as long as the loan is outstanding. These covenants generally require that the client maintain a:

	•	specified maximum ratio of senior debt to cash flow;
	•	specified maximum ratio of debt to equity;
	•	minimum level of earnings before interest, taxes, depreciation and amortization expenses; and
	•	minimum fixed charge coverage.

      Clients are also typically subject to limitations on their ability to make capital expenditures or distributions or to enter into capitalized leases.

      We make floating rate term loans secured by first mortgages on the facilities of the respective client. These loans generally range in size from $1 million to $40 million and have a term of two to five years. Our clients to which we make mortgage loans include:

	•	experienced owners and operators of hospitals, senior housing and skilled nursing facilities located in the United States;
	•	experienced owners and operators of office, industrial, hospitality, multi-family and residential properties;
	•	resort developers; and
	•	companies backed by private equity firms that frequently take out mortgages in connection with buyout transactions.

      Prior to extending a mortgage loan to a particular client, we perform extensive due diligence focusing on:

	•	the historic and projected cash flow of the mortgaged property;
	•	the condition of the property;
	•	the market positioning of the client;
	•	licensing and environmental issues related to the property and the client;
	•	the client’s management; and
	•	for HealthCare Finance clients, its operational expertise, its regulatory and clinical compliance, its reimbursement practices and its reputation in the local healthcare market.

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      Our mortgage loans contain typical financial covenants that require the client to, among other things, demonstrate satisfactory debt service coverage. The client is also typically limited in its ability to make distributions to its equity owners while the loan is outstanding. Because we underwrite our mortgage loans based on the value and cash flow of the underlying real estate rather than as an operating business, CapitalAnalytics generally does not perform the due diligence or underwriting procedures relating to these proposed loans. Our investment officers, however, perform full due diligence and valuation procedures for our mortgage loans.

      We frequently make Term B, second lien and mezzanine loans to clients that also have outstanding senior loans. A Term B loan is a loan that shares a first priority lien in the client’s collateral with the lenders on the client’s senior loan but that comes after a senior secured loan in order of payment preference upon a borrower’s liquidation and accordingly generally involves greater risk of loss than a senior secured loan. A second lien loan is a loan that has a lien on the client’s collateral that is junior in order of priority and also comes after the senior loans in order of payment. We also make mezzanine loans that may be either cash flow or real estate based loans. A mezzanine loan is a loan that does not share in the same collateral package as the client’s senior loans, may have no security interest in any of the client’s assets and comes after a senior secured loan in order of payment preference. A mezzanine loan generally involves greater risk of loss than a senior loan. We typically permit our Term B, second lien and mezzanine clients to maintain a higher ratio of debt to cash flow than we permit with respect to our senior secured, first lien loans. When we make a Term B, second lien or a mezzanine loan, we typically enter into an intercreditor agreement with the senior lenders of the client. These agreements limit our ability to exercise some of the rights and remedies to which we are entitled under the terms of our loan agreements. For example, typically we may not receive payments of principal on a mezzanine loan until the senior loan is paid in full and may not receive interest payments on the loan if the client is in default under the terms of the senior loan. In many instances, we are prohibited from foreclosing on a Term B, second lien or mezzanine loan until the senior loan is paid in full. A typical intercreditor agreement also requires that any amounts that we realize as a result of our collection efforts or in connection with a bankruptcy or insolvency proceeding involving the client be turned over to the senior lender until the senior lender has realized the full value of its own claims.

     HUD Mortgage Originations

      As a strategic supplement to our traditional healthcare lending business, we also act as an agent for the United States Department of Housing and Urban Development, or HUD, for the origination and servicing of federally insured mortgage loans to healthcare providers. Because we are a fully approved Federal Housing Authority Title II mortgagee, we have the ability to originate, underwrite, fund and service mortgage loans insured by the FHA. FHA is a branch of HUD which works through approved lending institutions to provide federal mortgage and loan insurance for housing and healthcare facilities.

      In addition to being an FHA approved lender, we are also an approved multifamily and healthcare MAP lender. MAP is a national “fast-track” processing system for the FHA Multifamily (and healthcare) mortgage insurance program. Being a MAP lender gives us more control over the loan application process, allowing us to prepare most of the exhibits required for an application for mortgage insurance and make a recommendation to HUD based upon the underwriting and conclusions of our credit committee. In turn, HUD reviews the package and makes the final credit decision.

      The HUD approval process may take up to nine months or more from application to approval. In many cases, we make a bridge loan to our clients providing them with needed liquidity prior to receipt of the HUD approval.

      As permitted by applicable federal regulations, we may receive fees for our services in originating or placing these federally insured loans. We sell the servicing rights to a third party for a fee. We may from time to time sell our interests in the federally insured loans we originate to third parties where we can do so at a premium to the principal amount of the loan originated.

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      Since we began offering our HUD mortgage origination services in March 2002, we have arranged for the commitment and closing of 13 loans insured by the FHA. These products have generated $5.6 million in revenue through December 31, 2003.

      In connection with some of our loans, we obtain, without making interest rate or other lending concessions, warrants to purchase equity in our borrowers. The warrants we obtain are generally exercisable at a nominal price, typically $0.01 per share. We obtain these warrants as a potential means of enhancing our yield from the related loans, and we expect to continue to seek warrants in connection with our loans where possible.

      We may also purchase equity in a borrower at the same time and on substantially the same terms as of one of our private equity sponsor clients. These equity purchases generally range from $250,000 to $2.0 million in any given client. As is the case with the warrants we obtain with our loans, we do not agree to any rate or lending concessions in the loans we make to these borrowers. Most often, these investments are acquired through our Corporate Finance group, which generates opportunities as a result of its relationships with private equity firms. In the course of evaluating a prospective client’s creditworthiness as a borrower, we also evaluate its prospects for growth. We make our equity investments in those cases where we conclude, based on the results of our diligence, that there is a likelihood we will receive a significant return on our equity investment. Our management expects that these equity co-investments will continue to be only an ancillary component of our business.

      We record warrants with cashless exercise features at fair value and use equity or cost method accounting for all other equity investments based on our ownership percentage. As of December 31, 2003, we accounted for our $39.8 million of equity interests as follows: $17.3 million — fair value; $1.7 million — equity; and $20.8 million — cost. As of December 31, 2003, the unrealized gain associated with the warrants that are carried at fair value totaled $7.2 million.

      As of December 31, 2003, we had also committed to contribute up to $12.3 million of capital to seven private equity funds. We made these commitments based on our close working knowledge of how the private equity funds make their investment decisions. As of December 31, 2003, we had also invested in a joint venture with a national real estate brokerage firm that regularly presents us with mortgage lending opportunities.

Portfolio Overview

      The schedule below shows the composition of our loan portfolio by type and by lending group as of the dates shown:

      As of December 31, 2003, our loan portfolio was well diversified, with 417 loans to 311 clients operating in multiple industries. As of December 31, 2003, we had $2.4 billion in loans outstanding. Throughout this section, unless specifically stated otherwise, all figures relate to our loans outstanding as of December 31, 2003.

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      Of our aggregate outstanding loan balance as of December 31, 2003, 40% was originated by our Corporate Finance group, 27% was originated by our HealthCare Finance group and 33% was originated by our Structured Finance group. On that date, 33% of the aggregate outstanding loan balance of our portfolio consisted of senior secured asset-based loans, 35% consisted of senior secured cash flow loans, 28% consisted of first mortgage loans and 4% consisted of mezzanine loans. Revolving loans comprised 33% of our portfolio while term loans comprised 67%.

      Our loans were made to clients in the following industries (percentages by loan balance):

Loan Balance by Industry

      The outstanding loan balances of our loans were distributed as follows:

Number of Loans By Loan Balance

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      No single client accounted for more than 3% of the aggregate outstanding balance of our loans, and our 10 largest clients collectively accounted for approximately 15% of the outstanding balance of our loans. The principal executive offices of our clients were located in 39 states and the District of Columbia, and no state accounted for more than 16% of the outstanding aggregate balance of our loans.

      Our loans provide for a contractual variable interest rate from approximately 0% to 16.0% above the prime rate. To mitigate the risk of declining yields if interest rates fall, we seek to include an interest rate floor in our loans whenever possible. Whether we are able to include an interest rate floor in the pricing of a particular loan is determined by a combination of factors, including the potential client’s need for capital and the degree of competition we face in the origination of loans of the proposed type. Where our competition to originate loans is high, such as in our Corporate Finance group, the inclusion of an interest rate floor often depends on the client’s desire to guard against rising interest rates by accepting the interest rate floor in return for a narrower margin over the prime rate than we would otherwise offer. As of December 31, 2003, 74% of the aggregate outstanding balance of our loans included such a minimum interest rate.

      Our loans generally have stated maturities at origination that range from two to five years. As of December 31, 2003, the weighted average maturity of our entire loan portfolio was approximately 4 years. As of December 31, 2003, the weighted average life of our entire loan portfolio was approximately 2.4 years. Our clients typically pay us an origination fee based on a percentage of the commitment amount and typically are required to pay a prepayment penalty for at least the first two years following origination. They also often pay us a fee based on any undrawn commitments as well as a collateral management fee in the case of our asset-based revolving loans.

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      The average size of our loans by lending group and across our overall portfolio were as follows:

	•	Corporate Finance — $7.3 million
	•	HealthCare Finance — $4.1 million
	•	Structured Finance — $6.4 million
	•	Overall Portfolio — $5.8 million

Origination, Underwriting and Servicing

      We have created an integrated approach to our loan origination and underwriting approval process that effectively combines the skills of our professionals with our proprietary information systems. This process allows us to move efficiently and quickly from our initial contact with a prospective client to the closing of our loan transaction while maintaining our rigorous underwriting standards. Along the way, a large number of CapitalSource professionals become involved in our analysis and decision-making with respect to each potential lending opportunity. We believe that the high level of staff involvement in the various phases of our approval process allows us to minimize our credit risk while delivering superior service to our clients.

Our Lending Process

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      Our loan origination process begins with our development officers who are charged with identifying, contacting and screening our prospective clients. Our development officers spend a significant portion of their time meeting face-to-face with key decision makers and deal referral sources such as private equity investors, business brokers, attorneys, investment bankers and executives within our target industries.

      To support our development officers, we actively market our business in an effort to build awareness of the CapitalSource brand and to generate potential financing opportunities. We have developed an aggressive marketing strategy focusing on enhancing the awareness of prospective clients of the CapitalSource brand. Components of this strategy include:

	•	development of relationships with private equity firms that we hope will result in the positioning of CapitalSource as the preferred source of financing for transactions among those firms and their portfolio companies;
	•	traditional marketing and brand development activities such as:

	•	selective advertising in trade publications within our targeted sectors, industries and markets;
	•	participation in regional and national conferences attended by prospective clients and potential referral sources;
	•	targeted direct mail efforts;
	•	telemarketing; and

	•	extensive cross-selling efforts where we market our one-stop shop of lending products to meet emerging financial needs of our clients as they arise.

      Once a prospect is identified, the development officer or an investment officer enters basic transaction data into our proprietary transaction management database, DealTracker. The development officer then works closely with one of our investment officers in the relevant lending group to describe the prospective client’s situation and financing needs. Based on these discussions the investment officer makes a determination whether to proceed with the prospect.

      If the investment officer determines that the potential transaction meets our initial credit standards, he or she prepares a term sheet. The term sheet is reviewed and approved by the managing director for the relevant lending group. In cases involving loans underwritten based on cash flow projections, the credit committee also generally reviews the proposed term sheet. The term sheet is linked to DealTracker and electronically distributed to the professional staff involved in the origination, credit and legal functions of our business. This distribution provides an opportunity for other investment officers and staff to review the proposed transaction and, as appropriate, provide comments and suggestions.

      Once the term sheet receives the required internal approvals, the term sheet is sent to the prospective client. The investment officer and the prospective client then negotiate the principal terms of the financing and, if the terms are agreed to, execute the term sheet.

      Once the term sheet has been executed, we typically require that the prospective client remit a good faith deposit to cover a portion of our direct out-of-pocket expenses as well as the due diligence and other expenses that we incur in connection with the proposed transaction, including outside and internal legal and auditing expenses and any third-party expenses. Once we receive this deposit, the responsible investment officer prepares an initial client memorandum briefly summarizing the terms of the proposed transaction and its associated risks. This memorandum is linked to DealTracker and distributed to our entire professional staff involved in the organization, credit and legal functions of our business. The relevant lending group also discusses the proposed transaction at its weekly professional staff meeting.

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      Following preparation of this initial client memorandum, for all transactions other than mortgage loans, the investment officer engages CapitalAnalytics, our wholly owned due diligence and field examination subsidiary, to perform comprehensive due diligence and underwriting procedures relating to the proposed transaction. The investment officer concurrently conducts detailed due diligence focusing on the prospect’s industry, business and financial condition and its management and sponsorship, if any. The investment officer works with our investment analysts in the applicable lending group to prepare a detailed memorandum describing and analyzing the proposed transaction. Once the investment officer’s memorandum is approved by the managing director of the applicable lending group, this memorandum and a memorandum prepared by the underwriting officer are circulated to members of the credit committee as well as other key individuals, and are also linked to DealTracker.

      CapitalAnalytics

      Because of the primary emphasis we place on credit and risk analysis, we have incorporated the underwriting, diligence and client examination functions into our lending process. We believe that the in-house examination and due diligence functions that CapitalAnalytics performs enable us to maintain a high level of quality control over these functions while delivering faster service than our competitors. The expertise of the professionals at CapitalAnalytics also facilitates our comprehensive efforts in the ongoing management of our portfolio, as discussed below.

      CapitalAnalytics is principally staffed by underwriting officers possessing significant levels of credit approval experience with banks, finance companies, accounting and/or audit firms. Within CapitalAnalytics, each of the underwriting officers and analysts is focused on a particular lending group. The underwriting officers work with our loan analysts and examiners to conduct a detailed, comprehensive accounting examination of prospective clients as part of the underwriting process.

      Unlike our development and investment officers who report to the managing directors of our lending groups, the CapitalAnalytics professionals report to our Chief Credit Officer. The Chief Credit Officer supervises, evaluates and determines the compensation of each CapitalAnalytics employee. All compensation decisions are based on factors such as the employee’s level of experience and position as well as a qualitative assessment of his work product. Quantitative factors such as the number and size of loans ultimately approved are not considered in determining compensation.

      Housing this important underwriting function in CapitalAnalytics is designed to ensure that the underwriting and credit analysis of each transaction is performed by professionals who have not had a role in identifying the prospect or negotiating the terms of the proposed loan. Because our CapitalAnalytics professionals report to the Chief Credit Officer rather than the managing directors of our lending groups, we believe that CapitalAnalytics is able to focus exclusively on ensuring the creditworthiness of our borrowers and our “credit first” philosophy. We believe that the compensation process for our CapitalAnalytics personnel further reinforces this orientation.

      The costs of the services provided by CapitalAnalytics are ultimately charged to the client. Services related to underwriting and credit analysis on each loan origination are capitalized and amortized as interest income over the life of the loan. Services relating to recurring diligence on existing loans and services on terminated loans are taken into income as the services are provided or when the loan is terminated, respectively. For the years ended December 31, 2003, 2002 and 2001, CapitalAnalytics charged to borrowers $6.0 million, $2.7 million and $0.8 million, respectively.

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      To apply consistent underwriting standards, CapitalAnalytics uses sector-specific due diligence methodologies that have been developed by our Chief Credit Officer and his staff. These procedures include detailed examinations and customized analyses by our underwriting teams of the following key factors of each client:

	•	the collateral securing the loan;
	•	the client’s historical and projected financial performance;
	•	its management, including thorough detailed background checks that occasionally involve private investigators;
	•	its operations and information systems;
	•	its accounting policies;
	•	its business model;
	•	fraud risk;
	•	its human resources;
	•	the legal and regulatory framework encompassing the prospective client’s operations; and
	•	the financial performance of the prospective client’s industry.

      As part of the evaluation of a proposed loan, the underwriting team prepares a comprehensive memorandum for presentation to the credit committee. The typical underwriting memorandum prepared by CapitalAnalytics for a prospective transaction generally consists of:

	•	a description of the business;
	•	an evaluation of risks specific to the business;
	•	a detailed analysis of the client’s historical and projected financial performance;
	•	an in-depth balance sheet and collateral analysis;
	•	a client-specific testing and analysis;
	•	the results of a number of other detailed examination procedures;
	•	a description of the client’s capital structure; and
	•	a description of the investment risk and return characteristics.

      When the underwriting memorandum is complete, it is provided to the director of credit of the relevant lending group for review. After any requested revisions are made, the lead underwriting officer submits the underwriting memorandum to the credit committee members and links it to DealTracker at the same time as the investment officer distributes his memorandum.

      In addition to the approval of the managing director for the relevant lending group, the unanimous approval of our credit committee is required before we make a loan. The four members of our credit committee are our Chief Executive Officer, our President, our Chief Credit Officer and our Chief Legal Officer. The credit committee generally meets weekly and more frequently on an as-needed basis. Prior to the credit committee meetings, our members review the separate memoranda prepared by the investment officer and CapitalAnalytics. At the meeting, the investment officer and lead underwriting officer for each transaction under consideration present their findings and recommendations to the committee members. The committee members then have the opportunity to discuss the transaction with the presenting officers and the managing director of the relevant lending group. Following the discussion, the committee votes on whether to approve the transaction.

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      If approved, the legal documentation process begins. Many of our loans are documented and closed by our 18-person in-house legal team. Other loans are outsourced to outside counsel who document and close loans under the supervision of our in-house legal department. The legal costs we incur in documenting and closing our loan transactions, whether attributable to in-house or outside legal counsel, are charged to our clients.

      The following chart illustrates the selectivity of our loan approval process:

Company Transaction Volume

      After a loan is approved and closed, the loan is assigned to a loan officer who enters it into our proprietary loan servicing system known as CapitalSource Asset Manager, or CAM. Each loan officer works within a specific lending group to provide tailored and highly customized servicing capabilities appropriate to that group. CapitalAnalytics also performs regularly scheduled examinations on the loan, with the frequency determined in part by the internal risk rating assigned to the loan. As with its initial diligence efforts, the costs of the regular examinations performed by CapitalAnalytics are charged to our clients.

      Each lending group has developed specific servicing and portfolio guidelines that are customized for the nuances of their particular sectors. The loan officers are generally responsible for:

	•	funding the loans in accordance with the credit committee approval;
	•	recording the loans into CAM;
	•	ensuring that billing and collections are performed in an accurate and timely fashion;
	•	ensuring that the client’s periodic compliance package is prepared in accordance with the loan covenant requirements;
	•	ensuring the mathematical accuracy of all covenant requirements;
	•	tracking the client’s actual performance periodically to ensure that the risk rating is appropriate;
	•	preparing quarterly reviews and updates for each client;
	•	collecting on past due accounts; and
	•	maintaining and releasing, as appropriate, the collateral in our possession.

      As of December 31, 2003, our loan officers managed an average of 13 accounts.

      Each week we hold a portfolio review meeting to review material events and information on our loans. These meetings are attended by each member of the credit committee as well as senior management of the

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      Additionally we undertake a more extensive quarterly re-evaluation of each loan. The extent of the review that we undertake for any particular loan is dictated by the complexity of the transaction and the consistency of the credit. Because we require more frequent examinations for asset intensive accounts, many accounts are actually examined on a quarterly basis. While the loan rating system described below identifies the relative risk for each transaction, the rating alone does not dictate the scope and/or frequency of any recurring examinations that we perform. The frequency of performing recurring examinations is determined by a number of factors, including the loan structure and type of collateral, the current financial performance of the client and the quality of the clients’ information systems.

Financing

      We depend on external financing sources to fund our operations. To date, we have employed a variety of financing arrangements including on balance sheet term debt transactions, credit facilities and repurchase agreements. We expect that we will continue to seek external financing sources in the future. Each of our existing financing arrangements is described in more detail in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition, Liquidity and Capital Resources.”

Non-Agented Loans

      We participate in loans originated by other lenders where we are not the agent. In these situations, we generally lend money to clients as part of a larger lending package arranged by another lender. As of December 31, 2003, approximately 8% of the aggregate outstanding balance of our loan portfolio was comprised of loans for which we are not the agent. In cases where we are not the agent for a particular loan, we are often subject to contractual arrangements that prohibit us from unilaterally taking actions to enforce or foreclose the loan. We generally may only take such actions with the agreement of other lenders holding a specified minimum aggregate percentage, generally a majority or two-thirds of the outstanding principal balance of the loans. We do not actively seek non-agented lending opportunities, but rather selectively participate in those offered to us by other lenders. In each case, we apply the same underwriting and credit standards in determining whether to participate in a co-lending arrangement as we would in evaluating whether to originate a loan ourselves.

Loan Ratings

      We have developed a comprehensive rating system and process to provide timely and accurate assessments of the credit risk inherent in each of our loans. While rating criteria vary by product, each loan rating focuses on the same three factors:

	•	credit;
	•	collateral; and
	•	financial reporting.

      Our loan officers conduct a quarterly review in which they rate each of the loans for which they are responsible. Some loans are reviewed more frequently. Following each review process, each loan file is passed to our portfolio review specialist for an independent review, using both objective and subjective criteria. Based on this review, the portfolio review specialist then submits a recommendation to affirm or change each proposed rating to our Chief Credit Officer.

      The Chief Credit Officer reviews these recommendations and makes a final decision with respect to proposed changes. Lower rated loans receive more scrutiny by our Chief Credit Officer. Once the ratings have been finalized each quarter, the Chief Credit Officer publishes the ratings to all of our professional staff.

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      In addition to our quarterly ratings review process, our credit committee affirms each loan rating in an intensive quarterly rating review meeting.

Proprietary Information Systems

      We believe that effective use of technology can streamline business functions, expedite loan turnaround time and enhance our loan servicing abilities. As of December 31, 2003, we employed 14 information systems employees, including eight network support personnel and three applications developers. In addition to widely used commercial software, we have developed two proprietary systems that we use in our daily operations:

	•	DealTracker, which tracks each potential transaction from prospect identification through termination or closing; and
	•	CapitalSource Asset Manager, or CAM, which tracks daily portfolio performance for our loan servicing function.

      DealTracker is a proprietary, web-based tracking system used for collecting information about a potential transaction, from the time a potential client is identified until the transaction closes or is terminated. DealTracker provides detailed information on the status of each transaction, including:

	•	the parameters of the deal, for example, loan type, commitment amount, rates and fees;
	•	the source of the deal;
	•	the identities of the CapitalSource investment officer and underwriting officer working on the deal; and
	•	a checklist of items required to close the deal and the status of each listed item.

      DealTracker also provides links to key documents for each transaction, including the:

	•	transaction term sheet;
	•&n