Morgan Stanley Direct Lending Fund — 2022 Form 10-K
Reporting period: Fiscal year ended December 31, 2022. This is an annual filing, not a standalone fourth-quarter report. Dollar figures below are in U.S. dollars; financial statement amounts are generally reported in thousands unless stated otherwise.
Business context
The Fund is an externally managed, non-diversified business development company (BDC) and intends to qualify as a regulated investment company (RIC). It lends primarily to U.S. middle-market, private-equity-sponsored companies, with a focus on directly originated senior secured, floating-rate loans. Morgan Stanley is the parent of the Adviser, but the Fund is not a Morgan Stanley subsidiary, and Morgan Stanley does not guarantee or otherwise commit to support the Fund beyond its affiliate’s stated equity commitment.
Financial and portfolio highlights
| Metric | 2022 | 2021 |
|---|---|---|
| Total investment income | $230.6 million | $119.8 million |
| Net investment income after taxes | $128.0 million | $72.9 million |
| Net change in unrealized appreciation/(depreciation) | $(80.0) million | $8.4 million |
| Net increase in net assets from operations | $48.5 million | $83.3 million |
| Net asset value per share at year-end | $19.81 | $20.91 |
| Net assets at year-end | $1.397 billion | $1.189 billion |
| Annual distributions per share | $1.92 | $2.07 |
- Income and returns: Investment income increased primarily from portfolio growth and higher LIBOR/SOFR benchmarks. Weighted-average yield on debt investments at amortized cost rose to 10.9% from 7.2%. Net investment income per share was $2.08; reported earnings per share were $0.79. Total return based on NAV was 3.99%, versus 14.83% in 2021.
- Portfolio: Fair value was $2.874 billion, up from $2.387 billion. The portfolio included 150 companies across 30 industries, compared with 98 companies across 27 industries. First-lien debt represented 93.8% of investment fair value, second-lien debt 4.5%, and other securities 1.7%. Insurance services and software were the largest reported industry exposures, at 15.7% and 14.3%, respectively.
- Credit quality: Approximately 99% of portfolio fair value was rated Category 2 under the Adviser’s internal scale and 1% Category 3; none was Category 4. One unsecured investment, with $1.5 million amortized cost and $0.372 million fair value, was on non-accrual. All first- and second-lien secured investments were reported current on interest payments. The Fund reported no realized losses from defaults or credit deterioration since investment operations began in January 2020 through year-end 2022.
- Cash flow and liquidity: Cash was $81.2 million at year-end. Operating activities used $429.8 million of cash, principally reflecting investment purchases; financing activities provided $436.9 million. The Fund reported $738.5 million of unused credit-facility capacity, subject to borrowing-base limits, and $220.3 million of uncalled stockholder commitments. It stated these resources were expected to cover near-term investment and operating needs.
- Debt and leverage: Year-end debt principal was $1.532 billion; carrying value was $1.523 billion. Asset coverage was 191.2%, compared with 195.1%. Average borrowings rose to $1.432 billion from $796 million, while the weighted-average borrowing rate increased to 4.05% from 2.12%. Debt included $425 million of 4.50% notes due 2027 and $275 million of 7.55% notes due 2025. The CIBC subscription facility matured and was repaid in 2022.
- Distributions and capital: The Fund declared $1.92 per share in 2022, or $119.4 million in total, versus $2.07 per share and $72.3 million in 2021; 2021 included a special distribution. Aggregate stockholder commitments were $1.629 billion, of which approximately $1.409 billion had been called. The NAV decline occurred despite increased net assets, supported by new capital and reinvested distributions.
Material changes versus 2021
- Investment income and net investment income increased substantially with portfolio expansion and higher reference rates, but unrealized depreciation of $80.0 million replaced 2021 unrealized appreciation of $8.4 million. The Fund attributed the depreciation mainly to market volatility and credit-spread widening.
- NAV per share fell by $1.10 to $19.81. Net assets nevertheless increased by $208.7 million, reflecting operations, $249.3 million of stock issuance, $30.3 million of reinvested distributions, and declared distributions.
- Investment fair value increased by about $486 million, and portfolio company count rose by 52. New investment commitments/purchases net of syndications were $739.8 million, down from $2.487 billion in 2021.
- Debt increased by approximately $282 million in principal terms, and the Fund issued the 2027 and 2025 notes. Higher average debt and borrowing costs contributed to interest and financing expense increasing to $67.2 million from $21.0 million.
- Category 3 investments rose from none to 1.0% of portfolio fair value, while the prior-year Category 1 allocation of 1.9% was no longer present.
Outlook, risks and notable items
- Management described direct lending as an attractive opportunity, citing higher reference rates, wider spreads, more conservative leverage and lender-friendly documentation. It also noted reduced leveraged-buyout activity and said investment pace would depend on market conditions, deal flow, inflation and portfolio-company performance. No specific earnings, yield or distribution guidance was provided.
- Management cited inflation, Federal Reserve and other central-bank rate increases, volatile energy prices, supply-chain disruptions and recession uncertainty as risks to borrowers and Fund results. While floating-rate loans may benefit from rising rates, higher borrower interest costs can also increase refinancing pressure and defaults; Fund borrowing costs rise as well.
- Approximately 22% of gross commitments were in loans described as covenant-lite. The portfolio was largely valued using Level 3, unobservable inputs, making fair values judgment-sensitive. Industry concentrations included insurance services, software and commercial services and supplies.
- Unfunded portfolio-company loan commitments were $314.3 million. The Adviser’s internal rating system, non-accrual exposure, unfunded commitments and loan valuations merit monitoring, particularly in a weaker economic environment.
- On January 31, 2023, the Truist facility’s stated maximum capacity was increased to $1.12 billion and its maturity extended to January 31, 2028 for consenting lenders. Through March 9, 2023, the Fund reported approximately $158.3 million of closed or approved/committed new and add-on investments.
- The Fund’s common stock had no established public market as of the filing date, and transfers are restricted. The investment period was extended to December 23, 2023. Morgan Stanley has no obligation to provide financial support beyond its affiliate’s $200 million equity commitment.
- Deloitte issued an unqualified opinion on the financial statements. Management concluded disclosure controls and internal control over financial reporting were effective as of year-end; the auditor did not provide an internal-control attestation because of applicable exemptions. No material legal proceedings were reported.
Most important facts for investors to verify
- Whether portfolio-company earnings, interest coverage and payment performance remain resilient as floating-rate borrower costs and recession risks evolve.
- How the $80.0 million unrealized depreciation, Level 3 valuations and the Category 3 loans change in subsequent reporting periods.
- Whether the 10.9% portfolio yield translates into sustainable cash income after the Fund’s higher debt costs, incentive fees and other expenses.
- Availability of borrowing capacity under borrowing-base tests, compliance with debt covenants, asset coverage and the timing of $314.3 million in unfunded portfolio commitments.
- Whether distributions are supported by cash earnings and taxable income, given 2022 distributions, the RIC distribution requirements and the Fund’s reported estimated $11.6 million taxable-income carryforward to 2023.
- Progress toward deployment before the investment period ends, and any future liquidity event; the filing provides no assurance of a public listing or secondary-market liquidity.