Morgan Stanley Direct Lending Fund — Q1 2022 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 filing covers the three months ended March 31, 2022, with comparisons to the three months ended March 31, 2021 and December 31, 2021 balance-sheet data. The company is not a subsidiary of, or consolidated with, Morgan Stanley, although its investment adviser and administrator are Morgan Stanley affiliates.
Key financial metrics
| Metric | Q1 2022 | Comparable/prior period |
|---|---|---|
| Total investment income | $44.3 million | $17.3 million in Q1 2021 |
| Net investment income after taxes | $26.5 million | $10.1 million in Q1 2021 |
| Net realized and unrealized gain/(loss) | $(4.3) million | $4.6 million gain in Q1 2021 |
| Net increase in net assets from operations | $22.2 million | $14.7 million in Q1 2021 |
| Net investment income per share | $0.46 | $0.59 in Q1 2021 |
| Earnings per share | $0.39 | $0.87 in Q1 2021 |
| Net asset value per share | $20.82 | $20.91 at December 31, 2021 |
| Cash flow from operating activities | $(125.2) million | $(276.5) million in Q1 2021 |
| Cash at period end | $38.9 million | $74.2 million at December 31, 2021 |
| Debt, net of issuance costs | $1.356 billion | $1.250 billion at December 31, 2021 |
| Net assets | $1.191 billion | $1.189 billion at December 31, 2021 |
Net expenses were $17.8 million, or approximately 40.2% of investment income. Net investment income represented approximately 59.8% of investment income. The annualized ratio of net expenses to average net assets was 4.79%, while the annualized ratio of net investment income to average net assets was 10.15%.
The portfolio had a fair value of $2.535 billion, up from $2.387 billion at year-end 2021. First-lien debt represented 93.1% of portfolio fair value, second-lien debt 5.2%, and other securities 1.7%. The portfolio comprised 109 companies across 27 industries. Approximately 100% of debt investments at fair value bore floating rates, with a weighted-average interest-rate floor of approximately 0.9% and a weighted-average debt yield of 7.2% at amortized cost.
Debt consisted of $310.4 million under the CIBC Subscription Facility, $435.5 million under the BNP Funding Facility, $191.5 million under the Truist Credit Facility and $425.0 million of 4.500% unsecured notes due 2027. Total committed debt capacity was $2.315 billion, with $952.7 million of unused capacity, subject to borrowing-base restrictions. The asset coverage ratio was 187.83%.
Material changes versus prior comparable periods
- Investment income increased 155.4% year over year, primarily because the portfolio expanded substantially, although the weighted-average asset yield declined from 7.4% to 7.2%.
- Net investment income increased 163.7% year over year, but net investment income per share declined because the weighted-average share count increased from 17.0 million to 57.1 million.
- Net realized and unrealized investment results declined from a $4.6 million gain to a $4.3 million loss. The unrealized loss was attributed primarily to valuation declines in a volatile credit environment.
- Interest and other financing expenses increased to $10.3 million from $2.8 million, reflecting substantially higher average borrowings and higher average borrowing costs.
- The company issued $425.0 million of 4.500% notes due February 2027 and reduced the CIBC facility commitment from $400.0 million to $315.0 million. Truist borrowings declined by $284.5 million, while the new notes increased total debt.
- The quarterly distribution increased to $0.48 per share from $0.45. The distribution exceeded reported quarterly net investment income per share of $0.46.
- Unfunded loan commitments declined to $437.3 million from $509.4 million. Stockholder capital commitments totaled $1.626 billion, including $465.9 million of unfunded commitments.
- Portfolio credit quality remained concentrated in internal Risk Rating 2 investments, representing 97.9% of portfolio fair value. One investment, representing 0.4%, was rated Risk Rating 3; none were rated Risk Rating 4.
Outlook, commentary, risks and unusual items
Management provided no formal numerical earnings or investment guidance. It stated that investment activity will depend on market conditions, deal flow and the continuing effects of the Coronavirus pandemic. Through May 10, 2022, the company had closed or committed approximately $145.5 million of new or add-on investments, including $144.4 million of first-lien senior secured loans and $1.1 million of equity investments.
Management believes the company and its portfolio are positioned to manage the current environment and continues to seek borrowers with strong management teams, substantial free cash flow, leading market positions and sustainable business models. The filing highlights risks from inflation, supply-chain disruption, economic uncertainty, market volatility, borrower performance, leverage, liquidity, interest-rate movements, illiquid Level 3 valuations, conflicts with affiliates and maintaining BDC and RIC status.
Fair value relied predominantly on Level 3 inputs and significant management judgment. A higher discount rate would reduce fair value. One unsecured debt investment with a fair value of $0.5 million was on non-accrual status; all first- and second-lien debt investments were reported as current on interest payments. The company reported compliance with all debt covenants and no material legal proceedings or senior-securities defaults.
The company’s interest-rate sensitivity analysis indicated that a 100-basis-point increase in rates would increase annualized net income by approximately $12.5 million, while modeled decreases of 100 to 300 basis points would increase annualized net income by approximately $2.5 million, assuming no change in portfolio or borrowing structure.
Most important facts for investors to verify
- Whether the $0.48 quarterly distribution is sustainably covered by recurring cash income, given reported net investment income of $0.46 per share and the inclusion of non-cash PIK income.
- The effect of increased leverage and the new 2027 notes on financing costs, asset coverage and covenant headroom.
- The quality and valuation sensitivity of the predominantly Level 3 portfolio, including the Risk Rating 3 investment and the non-accrual unsecured debt.
- Whether floating-rate asset income increases faster than borrowing costs as benchmark rates rise, including the effect of interest-rate floors.
- The company’s ability to fund $437.3 million of unfunded portfolio commitments while maintaining liquidity and meeting capital calls.
- The accuracy of portfolio-company operating data, valuation assumptions and concentration exposure across industries such as insurance services, software and commercial services.
- The expected closing and use of proceeds from the approximately $75.0 million capital drawdown notice delivered on May 4, 2022.