UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004

Commission File No. 1-31753

CapitalSource Inc.

(Exact name of registrant as specified in its charter)

4445 Willard Avenue, 12th Floor

Chevy Chase, MD 20815

(Address of Principal Executive Offices, Including Zip Code)

(800) 370-9431

(Registrant’s Telephone Number, Including Area Code)

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

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

None

      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.     þ Yes          o No

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

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

      The aggregate market value of the Registrant’s Common Stock, par value $0.01 per share, held by nonaffiliates of the Registrant, as of June 30, 2004 was approximately $1,581,973,000.

      As of March 1, 2005, the number of shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding was 118,224,120.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of CapitalSource Inc.’s Proxy Statement for the 2005 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

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 29 and in the section entitled “Risk Factors” on page 51 of this Form 10-K.

Overview

      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 small and medium-sized businesses with annual revenues generally ranging from $5 million to $500 million 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.

      From our inception in September 2000 through December 31, 2004, we made 923 loans representing an aggregate of $9.7 billion of total loan commitments. As of December 31, 2004, we had $4.3 billion in loans outstanding and commitments to lend up to an additional $2.1 billion to our clients. As of December 31, 2004, we had 398 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 businesses 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 businesses are:

      We price our loans based upon the risk profile of our clients. Although we occasionally make loans greater than $50 million, our loans generally range from $1 million to $50 million, with an average loan size as of December 31, 2004 of $6.6 million, and generally have a maturity of two to five years. As of December 31, 2004, senior secured cash flow loans comprised approximately 37% of our portfolio, senior secured asset-based loans comprised approximately 31% of our portfolio, first mortgage loans comprised approximately 26% of our portfolio and mezzanine loans comprised approximately 6% of our portfolio. As of December 31, 2004, our geographically diverse client base consisted of 452 clients with headquarters in 42 states and Washington, D.C.

Our Lending Businesses

      The following describes the particular characteristics of our three focused lending businesses: Corporate Finance, Healthcare and Specialty Finance, and Structured Finance.

      Corporate Finance 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:

      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 or 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 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, we believe most 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:

      Our financing transactions are generally structured as:

      We offer 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 make small equity investments in many of our clients.

      As of December 31, 2004, Corporate Finance had $1.7 billion in loans outstanding as well as commitments to loan an additional $429 million to 97 existing clients.

      Healthcare and Specialty Finance generally provides accounts receivable-based, inventory, short-term real estate, equipment, debtor-in-possession and other senior and mezzanine financing to small and medium-sized businesses throughout the United States. Our target markets are dominated by small to medium-sized businesses and typically exhibit rapid growth, consolidation and change.

      Despite what we perceive as a likelihood of significant opportunities due to the potential for growth, consolidation and restructurings in our target markets, companies operating in these 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 companies in our target markets, 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.

      We provide a broad range of asset-based and cash flow variable-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.

      Our financing activities are generally structured as:

      To date, we have focused substantially all of our efforts on clients in the healthcare market, the largest segment of the U.S. economy. Our healthcare clients often derive a significant portion of their revenues from third party reimbursements, particularly Medicaid and Medicare. 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.

      In addition to the healthcare industry, we have recently expanded our focus to other markets and sectors in order to better leverage our asset-based lending experience, including the security alarm industry. Prior to February 1, 2005, our security alarm industry loans were included in our Structured Finance Business and are reflected as such in the portfolio statistics throughout this Annual Report.

      As of December 31, 2004, Healthcare and Specialty Finance had $1.2 billion in loans outstanding as well as commitments to loan an additional $992 million to 151 existing clients.

      Structured Finance 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 senior term loans and revolving credit facilities 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. We target:

      We also conduct our commercial real estate lending practice within Structured Finance. We offer variable-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 on 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/or have 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 from 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, 2004, Structured Finance had $1.3 billion in loans outstanding as well as commitments to loan an additional $683 million to 204 existing clients.

Loan Products and Service Offerings

      The types of loan products and services offered by each of our lending businesses share common characteristics, and we generally underwrite the same types of loans across our three businesses 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 by eliminating the need for 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.

      Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable, inventory and/or machinery and equipment. 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 of the collateral securing our loan 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 and 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 eligible receivables.

      We perform industry-specific procedures when assessing the eligibility of receivables in originating asset-based loans in our Structured Finance and Healthcare and Specialty Finance Businesses. 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:

      With respect to asset-based loans to our healthcare clients, we conduct targeted examinations of the client’s accounts receivable due from third-party payors. Most of these receivables are payment obligations of federal and state Medicare and Medicaid programs and other government financed programs, commercial insurance companies, health maintenance organizations and other managed healthcare concerns. This evaluation typically includes:

      With respect to loans collateralized by a client’s inventory, we will advance funds against what we consider to be eligible inventory. 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.

      With respect to loans collateralized by machinery and equipment, we obtain third-party appraisals of the liquidation value of the collateral and use those appraisals to determine an appropriate liquidation value. We will consider lending at a discount to that value based on prevailing market conditions.

      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 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 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 $50 million and have a term of three to five years.

      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:

      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:

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

      We make variable 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:

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

      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, CapitalSource Analytics LLC, our wholly owned due diligence and field examination subsidiary described in detail below, 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 make Term B, second lien and, to a lesser extent, mezzanine 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. Term B loans are senior loans and, therefore, are included with senior secured loans in our portfolio statistics. 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.

      In connection with an acquisition of a company that provided mezzanine real estate loans, we acquired real estate assets that had been previously foreclosed on by the company we acquired. We have also foreclosed on real estate underlying loans we have originated, and we may foreclose on other real estate loans in our portfolio or acquire other portfolios that include real estate assets. As of December 31, 2004, we had $19.2 million of real estate owned.

      As a strategic supplement to our real estate lending business, we also act as an agent for the United States Department of Housing and Urban Development, or HUD, for the origination of federally insured mortgage loans. 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. From time to time, 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 may 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 or discount to the principal amount of the loan originated.

      Our HUD mortgage origination services generated $8.6 million, $4.8 million and $0.8 million in income for the years ended December 31, 2004, 2003 and 2002, respectively.

      We may purchase equity in a borrower at the same time and on substantially the same terms as one of our private equity sponsor clients. These equity purchases generally range from $250,000 to $2.0 million for any

given client. 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 Business, 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 due diligence, that there is 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.

      In connection with some of our loans, we obtain 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.

      As of December 31, 2004, we accounted for our $44.0 million of investments as follows: $5.7 million — fair value; $0.8 million — equity method; and $37.5 million — cost. As of December 31, 2004, the mark-to-market adjustments associated with the warrants that are carried at fair value totaled $(1.5) million.

      As of December 31, 2004, we had also committed to contribute up to $22.0 million of capital to ten 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, 2004, we had funded $6.0 million of our total commitment.

Portfolio Overview

      The composition of our loan portfolio by type as of December 31, 2004 and 2003 was as follows:

      As of December 31, 2004, our loan portfolio was well diversified, with 648 loans to 452 clients operating in multiple industries. We use the term “client” to mean the legal entity that is the borrower party to a loan agreement with us. As of December 31, 2004, we had $4.3 billion in loans outstanding. Throughout this section, unless specifically stated otherwise, all figures relate to our loans outstanding as of December 31, 2004.

      Of our aggregate outstanding loan balance as of December 31, 2004, 40% was originated by Corporate Finance, 29% was originated by Healthcare and Specialty Finance and 31% was originated by Structured Finance. Revolving loans comprised 29% of our portfolio and term loans comprised 71%.

      Our loan portfolio by industry as of December 31, 2004 was as follows (percentages by loan balance):

Loan Portfolio By Industry⁽¹⁾

      As of December 31, 2004, our loans ranged in size from $0.1 million to $100.4 million. Our loan portfolio by loan balance as of December 31, 2004 was as follows:

Loan Portfolio By Loan Balance

      Our loan portfolio by client balance as of December 31, 2004 was as follows:

Loan Portfolio By Client Balance

      We may have more than one loan to a client and its related entities. For purposes of determining the portfolio statistics in this Annual Report, we count each loan or client separately and do not aggregate loans to related entities.

      No client accounted for greater than 10% of our total revenues in 2004. The principal executive offices of our clients were located in 42 states and the District of Columbia, and no state accounted for more than 12% of the outstanding aggregate balance of our loan portfolio. In addition, we have loans in Canada and the United Kingdom which comprised less than 3% of the outstanding aggregate balance of our loan portfolio as of December 31, 2004.

      Our loan portfolio by geographic region as of December 31, 2004 was as follows:

Loan Portfolio By Geographic Region

      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.

      Our loans generally have stated maturities at origination that range from two to five years. As of December 31, 2004, the weighted average maturity and weighted average life of our entire loan portfolio was approximately 2.99 years and 2.46 years, respectively. 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.

      The average sizes of our loans by lending business and across our overall portfolio as of December 31, 2004 were as follows:

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

      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, 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:

      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 business 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. The relevant lending business also discusses the proposed transaction at its weekly professional staff meeting.

      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 a managing director for the relevant lending business. In cases involving loans underwritten based on cash flow projections, the credit committee also generally reviews an initial client memorandum prepared by the investment officer briefly summarizing the terms of the proposed transaction and its associated risks. The term sheet and the initial client memorandum are 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. Following the receipt of the deposit, 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 to prepare a detailed memorandum describing and analyzing the proposed transaction. Once the investment officer’s memorandum is approved by one of the managing directors of the applicable lending business, 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.

      Because of the primary emphasis we place on credit and risk analysis, we have incorporated the underwriting, due 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 business. 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 within our lending businesses, 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 transactions are 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 businesses, we believe that CapitalAnalytics is able to focus exclusively on ensuring the creditworthiness of our borrowers and our “credit first” philosophy.

      The majority of 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 due 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.

      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 performed by our underwriting teams and the legal department of the following key factors for each client:

      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:

      When the underwriting memorandum is complete, it is provided to the director of credit of the relevant lending business 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.

     Approval

      The unanimous approval of our credit committee is required before we make a loan. The members of our credit committee are our Chief Executive Officer, our President, our Chief Credit Officer, our Chief Legal Officer and for each loan proposed to be made by his lending business, the President of that lending business. The credit committee generally meets semi-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. Following the discussion, the committee votes on whether to approve the transaction.

      If approved, the legal documentation process begins. Many of our loans are documented and closed by our 28-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

Through December 31, 2004

      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 business to provide tailored and highly customized servicing capabilities appropriate to that business. CapitalAnalytics also performs regularly scheduled examinations on most loans. As with its initial

due diligence efforts, the costs of the regular examinations performed by CapitalAnalytics are charged to our clients.

      Each lending business has developed specific servicing and portfolio guidelines that are customized for its particular sectors. The loan officers are generally responsible for:

      As of December 31, 2004, our loan officers managed an average of 12 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 lending business whose loans are being discussed. The loan officer provides an update on the client accounts for which they are responsible. Loans are discussed at least monthly with more detailed discussions of loans that are performing below expectations.

      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 transact