Morgan Stanley Direct Lending Fund — Q1 2023 Form 10-Q
Business context and reporting period
Quarter ended March 31, 2023. The Fund is an externally managed, non-diversified business development company and regulated investment company focused primarily on directly originated senior secured loans to U.S. middle-market companies. It is advised by a Morgan Stanley affiliate but is not a subsidiary of, or consolidated with, Morgan Stanley; Morgan Stanley disclaims any obligation to provide financial support beyond its affiliate’s equity investment.
The interim financial statements were reviewed by Deloitte, not audited. The reviewer reported no material modifications needed for conformity with U.S. GAAP.
Financial performance and position
| Metric | Q1 2023 / March 31, 2023 | Comparable / prior date |
|---|---|---|
| Investment income | $83.6 million | $44.3 million in Q1 2022 |
| Net investment income | $44.2 million; $0.62 per share | $26.5 million; $0.46 per share |
| Net realized and unrealized result | Loss of $0.4 million, including $0.6 million unrealized depreciation | Loss of $4.3 million in Q1 2022 |
| Net increase in assets from operations | $43.8 million; $0.62 per share | $22.2 million; $0.39 per share |
| Net assets / NAV per share | $1.415 billion / $19.93 | $1.397 billion / $19.81 at December 31, 2022 |
| Portfolio investments, fair value | $2.926 billion | $2.874 billion at December 31, 2022 |
| Cash flows | Operating cash use of $16.4 million; financing cash inflow of $34.8 million; ending cash $99.6 million | Operating cash use of $125.2 million in Q1 2022; ending cash $38.9 million |
| Debt | $1.592 billion principal outstanding; $1.584 billion carrying value net of issuance costs | $1.532 billion principal outstanding at December 31, 2022 |
| Distributions | $0.50 per share declared; $35.4 million total | $0.48 per share; $27.5 million in Q1 2022 |
First-lien debt was 93.6% of portfolio fair value, second-lien debt 4.6%, and other securities 1.8%. Approximately 100% of the debt portfolio bore floating rates. The weighted-average debt yield at amortized cost was 11.5%, versus 7.2% in Q1 2022. The largest industry exposures were insurance services (15.5%), software (14.1%) and commercial services and supplies (11.1%).
Liquidity included $99.6 million cash, $200.0 million of reported BNP facility availability, $623.5 million under the Truist facility, and $220.3 million of uncalled investor commitments. Facility availability is subject to borrowing-base restrictions. Unfunded portfolio investment commitments were $257.0 million. Asset coverage was 188.84%.
Material changes versus the prior comparable period
- Investment income increased 89% year over year, primarily from portfolio growth and higher LIBOR/SOFR rates on floating-rate loans.
- Net investment income rose 67%, while interest and other financing expense increased to $26.7 million from $10.3 million. Management attributed the increase to higher average borrowings, higher reference rates and the cost of unsecured debt. Average borrowings were $1.585 billion versus $1.288 billion; the weighted-average borrowing rate was 6.23% versus 2.64%.
- Net investment portfolio fair value rose from $2.535 billion at March 31, 2022. The portfolio included 156 companies across 29 industries, compared with 150 companies across 30 industries at year-end 2022.
- Net unrealized depreciation was smaller than in Q1 2022 ($0.6 million versus $4.3 million), which management linked to credit-market volatility and spread movements.
- The annualized ratio of net expenses to average net assets increased to 9.19% from 4.79%; the annualized net investment income ratio rose to 14.57% from 10.15%. These ratios are not stated as conventional operating margins.
Outlook, risks, contingencies and unusual items
- Management said it believes the Fund and portfolio are positioned to manage current market conditions and sees potential for attractive risk-adjusted investment opportunities. Investment pace will depend on market conditions, deal flow, inflation’s impact on valuations and portfolio-company operations. Through May 10, 2023, the Fund closed about $23.6 million of new or add-on first-lien investments. No formal earnings or distribution guidance was provided.
- Management highlighted inflation, recession uncertainty, Federal Reserve rate increases, regional-bank developments, potential credit-market disruption, supply-chain interruptions and portfolio-company performance as risks. A new risk-factor disclosure warns that the Fund and portfolio companies may hold cash above FDIC insurance limits and could be affected by bank failures or wider financial-sector liquidity stress.
- At March 31, three portfolio companies representing 1.2% of portfolio fair value were rated Risk Category 3, up from two companies and 1.0% at year-end; none were Category 4. One $1.5 million unsecured debt investment was on non-accrual. All first- and second-lien secured investments were reported current on interest payments, and the Fund reported no realized losses from loan defaults or credit deterioration since investment operations began.
- Most investments are illiquid and valued using significant unobservable inputs: $2.866 billion of investments were Level 3. Fair values rely on estimates and could differ materially from proceeds in a forced sale. PIK income is non-cash but can count toward distributions needed for RIC tax treatment.
- Reported investment commitments and capital commitments create funding obligations. The Fund reported $256.99 million of unfunded portfolio commitments and $220.27 million of uncalled stockholder capital commitments. Management believed available resources were adequate to meet portfolio commitments in the near term.
- Debt covenants were in compliance at quarter-end. The Fund declared a $0.50 distribution per share payable April 25, 2023; part of distributions may be reinvested as shares. The Fund had no established public market for its common stock as of May 10, 2023.
- After quarter-end, the interim Chief Compliance Officer resigned effective May 8, 2023, and the Board appointed Gauranga Pal. The filing states the resignation was not due to disagreement with the Fund.
Most important facts for investors to verify
- Whether increased floating-rate income continues to exceed the rising cost of leverage, financing expenses and incentive fees.
- The credit quality and valuation assumptions for Level 3 holdings, Risk Category 3 loans, and the non-accrual investment.
- Actual borrowing capacity after borrowing-base limits, and the availability and timing of uncalled investor commitments to fund unfunded loans.
- The sustainability and cash coverage of the $0.50-per-share distribution, including the effects of PIK income and dividend reinvestment.
- Concentration, liquidity and interest-rate exposure: the portfolio is heavily weighted to first-lien floating-rate loans, and the filing’s hypothetical annualized net-income sensitivity to a 100-basis-point rate move is approximately $21.0 million in either direction, assuming no change in portfolio or borrowing structure.