Morgan Stanley Direct Lending Fund annual report, Q4 FY2021

Morgan Stanley Direct Lending Fund — FY2021 Form 10-K Summary

Business context and reporting period

The filing covers the year ended December 31, 2021, and was filed March 18, 2022. The Company is an externally managed business development company and regulated investment company focused primarily on directly originated, floating-rate senior secured loans to U.S. middle-market, sponsor-backed companies. It is advised and administered by Morgan Stanley affiliates but is not a subsidiary of, or consolidated with, Morgan Stanley; Morgan Stanley does not guarantee the Company’s obligations.

The Company commenced investing operations in January 2020. Its common stock was privately offered, there was no established public trading market, and total capital commitments were approximately $1.586 billion at year-end.

Financial and operating highlights

Metric	FY2021	FY2020	Change
Total investment income	$119.8 million	$21.9 million	Up materially
Net investment income after tax	$72.9 million	$10.6 million	Up materially
Net realized gain	$1.9 million	$2.2 million	Down modestly
Net unrealized appreciation	$8.4 million	$5.5 million	Up
Net increase in net assets from operations	$83.3 million	$18.3 million	Up materially
Net investment income per share	$2.34	$1.41	Up
Earnings per share	$2.67	$2.42	Up
Net asset value per share	$20.91	$20.08	Up 4.1%
Total return based on NAV	14.83%	7.07%	Up

Total investment income rose primarily because the fair value of investments increased from $637.0 million to $2.387 billion as capital was deployed. Net investment income after tax represented approximately 60.9% of investment income in 2021, compared with approximately 48.6% in 2020. The filing does not provide a conventional operating-company gross or operating margin.

• Portfolio: Fair value of $2.387 billion across 98 portfolio companies and 27 industries, compared with $637.0 million across 36 companies and 19 industries in 2020.
• Portfolio mix: First-lien debt represented 93.2% of investments at fair value, second-lien debt 5.1%, and other securities 1.7%.
• Yield and rates: Weighted average yield on debt investments was 7.2% at cost and 7.1% at fair value, compared with 7.5% and 7.4%, respectively, in 2020. Approximately 99.9% of debt investments were floating-rate, and approximately 99.3% had LIBOR floors.
• Credit quality: All first- and second-lien debt investments were reported as income-producing and current on interest payments. Internal risk ratings placed 98.1% of fair value in Category 2 and 1.9% in Category 1; none was rated Category 3 or 4.
• Investment activity: New net investment commitments were approximately $2.487 billion, new investment fundings were approximately $2.113 billion, and investments sold or repaid were approximately $384.7 million.
• Cash flow: Net cash used in operating activities was $1.661 billion, primarily reflecting investment purchases. Net cash provided by financing activities was $1.724 billion, resulting in a $62.9 million increase in cash to $74.2 million.
• Debt and leverage: Debt outstanding was $1.250 billion, compared with $333.9 million in 2020. Total committed credit facilities were $1.975 billion, with $725.2 million unused subject to borrowing-base restrictions. The asset coverage ratio was 195.1%, compared with 190.3% in 2020.
• Liquidity: The Company reported $74.2 million of cash, $725.2 million of credit-facility availability and $425.7 million of uncalled capital commitments, or more than $1.2 billion of stated available capital.
• Distributions: The Company declared total 2021 distributions of $2.07 per share, including a $0.11 special distribution, compared with $1.30 per share in 2020. Total declared distributions were $72.3 million.

Material changes versus the prior comparable period

• The investment portfolio expanded by approximately 275% in fair value, while the number of portfolio companies increased from 36 to 98.
• Capital deployment accelerated substantially, supported by $862.5 million of 2021 capital drawdowns versus $297.3 million in 2020.
• Leverage increased through the expansion of the CIBC facility, the use of the BNP Funding Facility and the addition of the $975 million Truist Credit Facility in July 2021.
• Debt-related expenses increased to $21.0 million from $3.7 million, primarily because average borrowings increased to approximately $796.3 million from $114.4 million.
• Gross base management fees increased to $13.9 million, income-based incentive fees to $15.9 million, and capital-gains incentive fees to $1.8 million. The Adviser waived $10.4 million of management fees in 2021.
• Portfolio diversification improved by company count and industry count, although insurance, commercial services and supplies, software, and IT services were among the larger industry exposures.
• Unfunded portfolio investment commitments increased to $509.4 million from $206.5 million, while unfunded investor capital commitments declined to $425.7 million from $1.148 billion.

Guidance, outlook, commentary, risks and unusual items

Management did not provide formal earnings or distribution guidance. It characterized the middle-market direct-lending environment as attractive and stated that it would continue emphasizing extensive due diligence, strong management teams, substantial free cash flow, leading market positions and sustainable business models. Investment pace is expected to depend on market conditions, deal flow and the continuing effects of COVID-19.

• COVID-19 and inflation: The Company could not reasonably estimate the future effects of the pandemic on financial condition, results of operations or cash flows. Supply-chain disruption, inflation, changing variants and economic weakness could impair portfolio companies.
• Interest-rate risk: Floating-rate assets may benefit from higher rates, but borrower defaults, refinancing pressure and higher borrowing costs could offset that benefit. The filing estimates that a 100-basis-point increase in rates would reduce annualized net income by approximately $5.0 million based on the year-end balance sheet and stated assumptions.
• LIBOR transition: The portfolio and credit facilities referenced LIBOR, creating documentation, valuation, operational and litigation risks as contracts transition to alternative rates such as SOFR.
• Leverage and financing: Borrowings magnify gains and losses. Credit facilities contain covenants and borrowing-base requirements; a default or inability to refinance could impair liquidity, distributions and investment activity.
• Valuation: Most investments were Level 3 and valued using significant unobservable inputs. Fair value changes may materially affect NAV, and realized proceeds may differ from reported fair values.
• Concentration and credit: Investments are below-investment-grade in risk characteristics, generally illiquid and exposed to borrower defaults, covenant breaches, collateral shortfalls, subordinated liens and prepayments.
• Conflicts and fees: The Adviser manages other accounts and MS BDCs with overlapping strategies. Allocation conflicts and incentive fees based partly on income and gains may not be fully aligned with stockholder interests.
• Tax and distributions: The Company must distribute sufficient taxable income to maintain RIC status. PIK interest and original issue discount can create taxable income without corresponding cash receipts.
• Liquidity: Common stock was privately held and illiquid. The Company targeted an exchange listing within four years of the initial closing, but there was no assurance that a listing or other liquidity event would occur.
• Subsequent events: Through March 18, 2022, the Company approved or closed approximately $178.6 million of new or add-on investments. It reduced the CIBC revolving commitment to $315 million, amended the facility, issued $425 million of 4.500% notes, and received $40.2 million of additional investor commitments, increasing total commitments to approximately $1.626 billion.
• Unusual disclosure inconsistency: Certain portions of the filing describe the $425 million notes as due 2028, while the subsequent-event disclosure and exhibits describe 4.500% notes due February 11, 2027. This maturity should be verified against the executed indenture and subsequent filings.

Most important facts for an investor to verify

1. Reconcile the reported $2.387 billion portfolio fair value, $1.250 billion of debt, $1.189 billion of NAV and the 195.1% asset coverage ratio.
2. Review borrowing-base availability and covenants for the CIBC, BNP and Truist facilities, including the post-year-end CIBC reduction and waiver.
3. Assess whether the 98.1% Category 2 internal risk rating adequately reflects borrower leverage, industry concentration and the $509.4 million of unfunded investment commitments.
4. Review Level 3 valuation assumptions, particularly discount rates, EBITDA and revenue multiples, and sensitivity of NAV to market spreads and interest rates.
5. Confirm the maturity, ranking, registration rights and effective cost of the $425 million notes, including the filing’s inconsistent 2027 versus 2028 references.
6. Evaluate the sustainability of distributions relative to net investment income, taxable income, PIK income and the Company’s RIC distribution requirements.
7. Review conflicts of interest, co-investment allocation procedures and the fee waiver and incentive-fee arrangements with Morgan Stanley affiliates.