Morgan Stanley Direct Lending Fund quarterly report, Q3 FY2022

Morgan Stanley Direct Lending Fund — Form 10-Q Summary

Business context and reporting period

Morgan Stanley Direct Lending Fund is a non-diversified, externally managed business development company focused primarily on directly originated senior secured loans to U.S. middle-market companies. The fund is also intended to qualify as a regulated investment company. The filing covers the three and nine months ended September 30, 2022, with comparative periods ended September 30, 2021, and balance-sheet comparisons to December 31, 2021. There was no established public market for the common stock as of November 8, 2022.

Key financial metrics

Metric	Three months ended September 30, 2022	Nine months ended September 30, 2022
Total investment income	$62.7 million	$157.0 million
Net investment income after taxes	$33.8 million	$89.7 million
Net realized gain	$18 thousand	$556 thousand
Net unrealized depreciation	$(24.4) million	$(61.9) million
Net increase in net assets from operations	$9.4 million	$28.4 million
Earnings per share	$0.15	$0.47
Dividends declared per share	Not separately stated for the quarter	$1.42

Net assets were $1.307 billion at September 30, 2022, compared with $1.189 billion at December 31, 2021.
Net asset value per share declined to $20.00 from $20.91 at year-end 2021.
The investment portfolio had a fair value of $2.747 billion, compared with $2.387 billion at December 31, 2021. First-lien debt represented 93.5% of investments at fair value, second-lien debt 4.8%, and other securities 1.7%.
Net expenses were $28.9 million for the quarter and $67.3 million year to date. Management-fee waivers reduced expenses by $5.1 million and $14.7 million, respectively.
The annualized ratio of net expenses to average net assets was 6.70%; the ratio of net investment income to average net assets was 9.95% for the nine-month period.
Cash was $59.9 million at September 30, 2022. Operating activities used $375.5 million of cash, while financing activities provided $361.2 million, resulting in a $14.3 million decrease in cash year to date.

Debt and liquidity

Total debt at carrying value was $1.515 billion, compared with $1.250 billion at December 31, 2021. Debt included $220.4 million under the CIBC Subscription Facility, $322.0 million under the BNP Funding Facility, $282.2 million under the Truist Credit Facility, $425.0 million of 2027 Notes, and $275.0 million of 2025 Notes.
Aggregate committed debt capacity was $2.510 billion, with approximately $984.3 million of unused capacity, subject to borrowing-base restrictions.
The fund issued $425 million of 4.50% unsecured notes due 2027 in February 2022 and $275 million of 7.55% unsecured notes due 2025 in September 2022.
The combined weighted-average interest rate on borrowings was 4.37% for the quarter and 3.47% year to date, compared with 2.16% and 2.10% in the respective 2021 periods.
Capital commitments from stockholders totaled approximately $1.624 billion, of which $309.4 million was unfunded. Unfunded portfolio investment commitments were $338.3 million.
Management stated that cash, available credit capacity, and uncalled capital commitments were expected to be sufficient for near-term investing and operating needs. The fund was in compliance with debt covenants.

Material changes versus comparable periods

Total investment income more than doubled, increasing 98% for both the quarter and nine-month period, primarily because of a larger invested portfolio and higher floating-rate yields.
Net investment income increased 80% for the quarter and 100% year to date, but net investment income per share declined to $0.53 for the quarter and $1.49 year to date from $0.54 and $1.74, respectively, reflecting substantial share issuance and portfolio growth.
Net results were reduced by unrealized depreciation of $24.4 million for the quarter and $61.9 million year to date, compared with unrealized appreciation in the 2021 periods. Management attributed the decline primarily to credit-market volatility and spread widening.
Net increase in net assets from operations fell to $9.4 million for the quarter and $28.4 million year to date from $22.2 million and $56.8 million, respectively.
Shares outstanding increased to 65.4 million from 56.8 million at December 31, 2021. The fund issued $154.7 million of common stock through two capital calls during the nine months.
Portfolio companies increased to 139 across 29 industries from 98 across 27 industries at December 31, 2021. The weighted-average yield on debt investments at amortized cost increased to 9.6% from 7.2% at year-end 2021.
Unfunded commitments declined to $338.3 million from $509.4 million at year-end 2021, while available debt capacity increased to approximately $984.3 million from $725.2 million.

Guidance, outlook, risks and unusual items

No formal earnings or dividend guidance was provided. The filing states that investment pace will depend on market conditions, deal flow, inflation, valuations, and portfolio-company operating performance.
Through November 8, 2022, the fund had closed or committed approximately $45.3 million of new or add-on investments, including $43.0 million of first-lien loans and $2.3 million of other securities.
Management cited inflation, rising interest rates, supply-chain disruptions, potential recession, market volatility, geopolitical instability, and the Russia-Ukraine conflict as material risks.
Virtually all debt investments were floating rate, which supports investment income as rates rise but increases borrower stress and financing costs. Management estimated that a 100-basis-point increase in rates would increase annualized net income by approximately $19.7 million, while a 100-basis-point decrease would reduce it by approximately $19.6 million, assuming no changes in portfolio or leverage.
One $1.8 million unsecured debt investment was on non-accrual status. All first- and second-lien debt investments were reported as current on interest payments, and the fund reported no realized losses from defaults or credit deterioration since inception.
Approximately 99.0% of the portfolio at fair value was internally rated Category 2, with 1.0% rated Category 3 and none rated Category 4. Most investments were Level 3 assets valued using significant unobservable inputs, creating valuation uncertainty.
The adviser waived management fees before a public listing to cap the effective base fee at 0.25% of average gross assets; these waivers are not subject to recoupment. Morgan Stanley has no obligation to provide financial support beyond its equity investment.
The company reported effective disclosure controls, no material legal proceedings, no defaults upon senior securities, and no material subsequent events other than $5.4 million of additional capital commitments closed on October 27, 2022.

Important facts for investors to verify

Reconcile the decline in NAV per share to unrealized depreciation, dividends, share issuance, and changes in portfolio valuations.
Review the sensitivity of net investment income to further interest-rate increases, including the effect of higher borrowing costs and borrower credit stress.
Assess the valuation assumptions for the predominantly Level 3 portfolio, particularly discount rates, comparable-company multiples, and spread-widening effects.
Monitor the $1.8 million non-accrual investment, the two Category 3 investments, unfunded commitments, and near-term portfolio maturities.
Confirm the availability and borrowing-base requirements of the $984.3 million of unused debt capacity and the $309.4 million of uncalled equity commitments.
Evaluate the sustainability of distributions relative to net investment income, including the impact of non-cash PIK income, incentive fees, and future management-fee waivers.
Consider the absence of a public market for the common stock and the related limitations on liquidity and price discovery.