Morgan Stanley Direct Lending Fund — Q2 2023 Form 10-Q
Business context and reporting period
Quarter and six months ended June 30, 2023. The Fund is an externally managed, non-diversified business development company focused on lending to U.S. middle-market companies, primarily through directly originated senior secured loans. Its investment adviser is an indirect Morgan Stanley subsidiary, but the Fund is not a subsidiary of or consolidated with Morgan Stanley; Morgan Stanley states it has no obligation to support the Fund beyond its equity investment.
Financial performance and position
| Metric | Q2 2023 | Six months 2023 |
|---|---|---|
| Investment income | $88.9 million | $172.5 million |
| Net investment income | $47.8 million; $0.67/share | $92.0 million; $1.29/share |
| Net increase in net assets from operations | $56.4 million; $0.79/share | $100.2 million; $1.41/share |
| Operating cash flow | Not presented for the quarter | $(7.4) million |
At June 30, total assets were $3.071 billion, investments at fair value were $2.984 billion, net assets were $1.440 billion, and NAV was $20.15 per share (versus $19.81 at year-end 2022). The portfolio comprised 159 companies across 29 industries; 93.8% of investment fair value was first-lien debt, 4.4% second-lien debt, and 1.8% other securities. Debt investments were approximately 100% floating-rate. Weighted average debt yield at amortized cost was 11.8%.
Debt had a $1.562 billion principal balance and $1.555 billion carrying value. The combined weighted average borrowing rate was 6.47% for Q2 and 6.35% for the first half. Cash was $52.9 million; available capacity under the BNP and Truist facilities was $856.5 million combined, subject to borrowing-base limits. Uncalled investor capital commitments were $220.3 million, compared with $245.6 million of unfunded portfolio commitments. Asset coverage was 192.17%. Net investment income was approximately 53.8% of investment income in Q2 and 53.3% for the first half.
Changes versus comparable periods
- Q2 investment income rose to $88.9 million from $50.0 million; net investment income rose to $47.8 million from $29.4 million. Operations produced $56.4 million versus a $3.3 million loss in Q2 2022, when unrealized depreciation was significant.
- For the first half, investment income increased to $172.5 million from $94.3 million and net investment income to $92.0 million from $55.9 million. Unrealized investment results shifted to $8.1 million appreciation from $37.5 million depreciation.
- Management attributed higher investment income primarily to capital deployment and increased floating reference rates. Higher rates, higher average borrowings, and more expensive unsecured debt drove interest and financing expense to $54.6 million for the first half, versus $24.1 million.
- Portfolio fair value increased $110.1 million from December 31, 2022. NAV rose $0.34 per share during the first half. Distributions declared were $1.07 per share, including a $0.07 supplemental distribution, versus $0.95 a year earlier.
- Risk rating 3 investments rose to 1.5% of portfolio fair value from 1.0%; there were no risk rating 4 investments. One $1.5 million-cost unsecured debt investment was on non-accrual.
Outlook, risks and unusual items
Management said available cash, borrowing capacity, and uncalled capital commitments were expected to support near-term operations and investing, including unfunded portfolio commitments. Subsequent to quarter-end through August 9, the Fund closed approximately $71.6 million of new or add-on investments. Management cited inflation, recession uncertainty, higher rates, regional-bank failures, and potential credit-market disruption, while stating it believed the Fund and portfolio were positioned to manage the environment and that market conditions could offer investment opportunities. No quantified earnings or distribution guidance was provided.
- Interest-rate exposure: A hypothetical 100-basis-point increase in reference rates was estimated to raise annualized net income by $21.7 million; a 100-basis-point decrease was estimated to reduce it by the same amount, assuming the June 30 portfolio and borrowing structure. The Fund did not hedge interest rates during the reported periods.
- Valuation and credit: Most investments are illiquid and valued using significant unobservable inputs; Level 3 investments were $2.925 billion. Forced-sale values could differ materially from reported fair values. The portfolio was concentrated in insurance services (15.5%), software (14.3%), and commercial services and supplies (10.6%) by fair value.
- Leverage and liquidity: Facility availability is subject to borrowing-base restrictions; floating-rate asset income is offset partly by floating-rate borrowing costs. The Fund reported compliance with debt covenants at June 30.
- Other disclosures: The filing identifies LIBOR transition risk, related-party conflicts, and broader economic and portfolio-company risks. Management reported no material legal proceedings, no material control changes, and effective disclosure controls. The auditor’s interim review found no material modifications necessary; it was not an audit opinion.
Key facts investors should verify
- Portfolio-company credit quality, especially the five risk rating 3 positions and the non-accrual unsecured investment, including subsequent collections and valuation changes.
- Borrowing-base availability and covenant headroom under the BNP and Truist facilities, and the effect of rates on both investment income and funding costs.
- Ability to meet $245.6 million of unfunded portfolio commitments given $220.3 million of uncalled investor commitments and facility restrictions.
- Support for Level 3 valuations, portfolio-company concentration, and the assumptions behind reported fair values and yields.
- Sustainability of distributions relative to cash income, incentive fees, and non-cash PIK income; the filing provides no forward distribution or earnings guidance.
- Progress and contractual implications of the LIBOR transition, and the terms and effects of the Fund’s related-party arrangements.