Morgan Stanley Direct Lending Fund quarterly report, Q3 FY2020

Morgan Stanley Direct Lending Fund — Q3 2020 Form 10-Q Summary

Business Context and Reporting Period

Morgan Stanley Direct Lending Fund is an externally managed business development company focused primarily on directly originated senior secured loans to U.S. middle-market, sponsor-backed companies. The fund commenced investing operations on January 31, 2020. This filing covers the quarter and nine months ended September 30, 2020; 2019 comparisons primarily reflect the pre-investment formation period and are not economically comparable.

The interim financial statements were reviewed by Deloitte & Touche LLP, not audited. Management reported effective disclosure controls and no material changes in internal control over financial reporting.

Financial Metrics

Metric	Three Months Ended September 30, 2020	Nine Months Ended September 30, 2020
Total investment income	$5.7 million	$10.5 million
Net expenses	$3.8 million	$6.5 million
Net investment income	$1.8 million	$3.9 million
Net realized gain	$0.8 million	$2.2 million
Net unrealized appreciation	$4.0 million	$2.1 million
Net increase in net assets from operations	$6.6 million	$8.2 million
Net investment income per share	$0.25	$0.71
Net earnings per share	$0.91	$1.48
Dividend declared per share	$0.40	$0.69

Net assets were $229.9 million at September 30, 2020, compared with $(1.1) million at December 31, 2019. Net asset value was $19.87 per share versus $(640.54) at year-end 2019, when only 1,750 seed shares were outstanding.
Cash was $112.9 million. Portfolio investments had a fair value of $336.3 million, compared with no investments at December 31, 2019.
Annualized net expense and net investment income ratios were 6.50% and 4.82%, respectively. The ratio of expenses before waivers was 7.48%.
The portfolio consisted of 19 companies across 10 industries. First-lien debt represented 95.8% of investments at fair value and second-lien debt represented 4.2%. All debt investments were floating-rate; approximately 91.3% had LIBOR floors. Weighted-average yield was approximately 7.6%.
All portfolio investments were classified as Level 3 fair-value measurements, requiring significant management judgment and unobservable inputs. Fair value exceeded amortized cost by $2.1 million.

Cash Flow, Debt and Liquidity

Net cash used in operating activities was $291.3 million, primarily reflecting $344.6 million of investment purchases, partially offset by $47.5 million of investment sale proceeds and principal repayments.
Financing activities provided $404.2 million, including $391.4 million of credit-facility borrowings and $224.9 million of common-stock proceeds, offset by $210.0 million of debt repayments and $1.3 million of cash dividends.
Debt outstanding under the CIBC Subscription Facility was $181.4 million at September 30, 2020, with $143.7 million of stated remaining capacity. The facility matures December 31, 2022 and had a weighted-average borrowing rate of 1.98% for the nine-month period.
Total stockholder capital commitments were $1.403 billion, of which $1.175 billion remained unfunded. The fund had $156.2 million of unfunded loan commitments to portfolio companies.
The asset coverage ratio was 226.79%, above the 150% regulatory minimum cited in the filing.

Material Changes Versus the Prior Comparable Period

The fund transitioned from a formation-stage entity with no investment portfolio at December 31, 2019 to a $336.3 million fair-value loan portfolio by September 30, 2020.
Capital commitments increased from $755.3 million at December 31, 2019 to $1.403 billion, while shares outstanding increased to 11.6 million from 1,750 seed shares.
The fund began using leverage, with $181.4 million of debt outstanding compared with none at December 31, 2019.
Third-quarter investment activity included approximately $284.0 million of new commitments, $149.4 million of fundings, and approximately $11.3 million of investment sales that generated approximately $0.8 million of realized gains.
All investments were internally rated Category 2, meaning management viewed them as performing in line with initial underwriting expectations. The filing states that all debt investments were current on interest payments.
Management and incentive fees became material expenses as the portfolio scaled. Third-quarter gross management fees were $637,000, income-based incentive fees were $551,000, and capital-gain incentive fees were $750,000. Management-fee waivers reduced quarterly expenses by $478,000.

Outlook, Commentary, Risks and Unusual Items

Management described the fund as well positioned for the COVID-19 environment because it had a limited pre-COVID portfolio, substantial uncalled capital, and an emphasis on senior secured lending to generally non-cyclical industries. No exposure was reported to airlines, lodging or leisure.
Management intends to continue investing during the three-year investment period when opportunities meet its underwriting standards. No formal earnings or dividend guidance was provided.
From October 1 through November 6, 2020, the fund closed or had investment committee commitments or approvals for approximately $274.5 million of new or add-on investments: 72.5% first lien, 27.0% second lien and 0.5% common equity.
On October 14, 2020, a wholly owned subsidiary entered into a BNP Paribas revolving funding facility of up to $300 million. The facility has a reinvestment period through October 13, 2023 and final maturity on October 13, 2025, subject to specified extensions. It is secured by the subsidiary’s assets and introduces additional structural and borrowing-base risks.
COVID-19, market volatility, borrower defaults, loan valuation uncertainty, lower LIBOR, portfolio-company liquidity needs and possible covenant breaches remain significant risks. A prolonged decline in interest rates could reduce investment income.
All investments and the CIBC facility have floating-rate features. The filing estimates that a 100-basis-point increase in rates would reduce annualized net income by approximately $862,000, while decreases of 100 basis points or more would increase annualized net income by approximately $212,000, based on the September 30 portfolio and debt structure.
Fair-value gains include unrealized appreciation and may not be realized. Capital-gain incentive fees are accrued under GAAP on certain unrealized appreciation, although payment generally crystallizes only when gains are realized under the advisory agreement.
The fund received SEC exemptive relief on September 18, 2020 permitting certain negotiated co-investments with affiliated accounts, subject to conditions.

Investor Verification Checklist

Verify the collectability and valuation assumptions for the entirely Level 3 portfolio, including discount rates, indicative pricing and borrower cash-flow assumptions.
Monitor COVID-19 effects, borrower performance, interest-payment status, internal risk ratings and any loans placed on non-accrual.
Reconcile cash, uncalled capital commitments, the $181.4 million CIBC debt balance and the $156.2 million of unfunded portfolio commitments.
Assess the effect of leverage, the CIBC maturity, the new BNP facility, borrowing-base requirements and applicable asset-coverage limits.
Evaluate whether net investment income supports the $0.40 quarterly dividend and whether future distributions could include return of capital.
Review related-party management, incentive and administrative fees, including fee waivers and potential reimbursement of waived organization and offering expenses.
Track the transition away from LIBOR and the effect of rate floors, spread changes and benchmark replacement provisions.