Morgan Stanley Direct Lending Fund (NYSE:MSDL) Q3 2024 Earnings Call Transcript

Morgan Stanley Direct Lending Fund (NYSE:MSDL) Q3 2024 Earnings Call Transcript November 8, 2024

Operator: Please stand by. Welcome to the Morgan Stanley Direct Lending Fund’s Third Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the prepared remarks. As a reminder, this conference call is being recorded. At this time, I’d like to turn the call over to Michael Occi, Head of Investor Relations and Chief Administrative Officer. Please go ahead.

Michael Occi: Good morning. And welcome to Morgan Stanley Direct Lending Fund’s third quarter 2024 earnings call. Joining me this morning are Jeff Levin, President and Chief Executive Officer; David Pessah, Chief Financial Officer; and Rebecca Shaoul, Head of Portfolio Management. Morgan Stanley Direct Lending Fund’s third quarter 2024 financial results were released yesterday after market closed and can be accessed on the Investor Relations section of our website at www.msdl.com. We have arranged for a replay of today’s event that will be accessible from the Morgan Stanley Direct Lending Fund website. During this call, I want to remind you that we may make forward-looking statements based on current expectations. The statements on this call that are not purely historical are forward-looking statements.

These forward-looking statements are not a guarantee of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements, including and without limitation market conditions, uncertainty surrounding interest rates, changing economic conditions, and other factors we have identified in our filings with the SEC. Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions can be incorrect. You should not place undue reliance on these forward-looking statements.

The forward-looking statements contained on this call are made of as of the date hereof and we assume no obligation to update the forward-looking statements or subsequent events. To obtain copies of SEC related filings, please visit our website. With that, I will now turn the call over to Jeff Levin.

Jeff Levin: Thank you, Michael. Thank you for joining us today for Morgan Stanley Direct Lending’s third quarter 2024 conference call. We are proud of the strong results that we generated during the quarter. I will first begin with an overview of our performance in the quarter before discussing our market outlook. Dave will then provide updates on our portfolio and comment on the financial results. Our team delivered portfolio growth and solid operating results for the third quarter, supported by strong credit performance. At $20.83 net asset value per share was unchanged quarter-over-quarter. We generated net investment income of $0.66 per share, an increase from the $0.63 per share of net investment income earned in the second quarter and comfortably in excess of the $0.50 per share regular dividend we declared for the quarter, combined with the $0.10 special dividend.

Recall that the latter had been declared by the Board of Directors around the time of the IPO and was paid to shareholders of record as of August 5, 2024. For the third quarter, new investment commitments totaled approximately $455 million in 37 portfolio companies. Net funded deployment for the quarter was $124 million, as compared with $210 million in the second quarter. During the quarter, MSDL’s debt to NAV increased from 0.9 times to 0.99 times, which is a significant increase and was effectively at the low end of our 1 to 1.25 target leverage range. I’m proud to say that we accomplished that without stretching on credit. Our deployment activity in the quarter showcased once again our ability to leverage our unique origination engine to drive quality deal flow.

During the third quarter, we led or co-led approximately 90% of the new borrowers added to MSDL’s portfolio. We believe sponsors are drawn to the quality of our team and our ability to be a value add partner, given the broader Morgan Stanley platform we are a part of. In our view, these deals continue to be favorable from a credit perspective, when you consider the leverage and loan-to-value profiles, among other attributes. That’s a good segue to the market outlook. A resilient backdrop has defined the first nine months of 2024, marked by strong economic outperformance against the backdrop of a potential soft landing and anticipated policy easing. The Federal Reserve’s 50 basis point rate cut in September spurred market optimism, followed more than a year of base rates in excess of 5%.

While we believe that base rates will trend modestly lower, gross asset yields are likely to continue to remain elevated, offering attractive opportunities for us, particularly when risk adjusted. Credit performance has continued to be solid, which we believe is a reflection of the resilience of the middle market economy. Regarding deal activity, we view the capital market rebound as firmly on track, with sponsor M&A likely to accelerate into 2025, as we emerge from the U.S. election and gain more visibility on the direction for interest rates. We see a growing desire for private equity firms and other asset owners to transact, due to LP dynamics, and generally more conducive private and public financing markets. We expect that sponsors are increasingly likely to deploy capital, which we believe will create lending opportunities for us.

As the market environment evolves, we believe MSDL’s differentiation among direct lenders will continue to come into full focus. Since our IPO in January, we’ve highlighted the clear benefits of our ability to leverage the broader Morgan Stanley platform. Our breadth and depth of sponsor relationships allows us to see a vast range of deal flow and that deal flow grossly exceeds our capital base, which breeds selectivity and flexibility. We think that this supply-demand imbalance will continue to serve as a key competitive advantage. We look forward to continuing to source and underwrite lending opportunities that offer strong risk-adjusted returns, and in turn, create value for MSDL shareholders. With that, I would like to hand the call over to David, who will provide details on Morgan Stanley Direct Lending Fund’s portfolio, investment activity and financial results.

David Pessah: Thank you, Jeff. Starting with our portfolio, we ended the third quarter with a total portfolio at fair value of $3.6 billion, which was comprised of 96% first-lien debt, 2% second-lien debt and the remainder in equity and other investments. As of September 30th, we had investments in 200 portfolio companies spanning across 33 industries, with nearly 100% of our investments in floating rate debt. Our two largest industry exposures remain in software and insurance services, which accounted for 17.7% and 12.6% of the portfolio at fair value, respectively. The average position size of our investments was approximately $18.2 million or approximately 50 basis points of our total portfolio on a fair value basis. Further, our top 10 portfolio companies represented approximately 17% at fair value of the total portfolio.

At the end of the third quarter, our weighted average loan-to-value was approximately 40% and the weighted average EBITDA of our portfolio companies was $145 million, and the median EBITDA was approximately $85 million. As of September 30th, our weighted average yield on debt and income-producing investments was 11% at both fair value and cost. Turning to credit quality, over 98% of our total portfolio had an internal risk rating of 2 or better, which is relatively unchanged from the second quarter. During the quarter, our first-lien investment in Matrix Parent was restructured into first-lien debt and common equity, and was subsequently restored to accrual status. As of September 30th, we had investments in two portfolio companies on non-accrual status, which represents $8.1 million or 20 basis points of the portfolio at cost.

For our investment activity in the third quarter, we made new investment commitments of approximately $455 million in 19 new portfolio companies and 18 existing portfolio companies across nine industries. Investment fundings totaled $377 million, with $253 million in repayments for net funded investment activity of $124 million. Turning to our financial results for the third quarter, our total investment income was $110 million for the third quarter, as compared to $104.2 million at the prior quarter. The increase was driven by recurrent interest income from deployment and repayment-related income. PIK income continues to remain relatively low, amounted to only 2% of total investment income. Net investment income for the third quarter was $58.7 million or $0.66 per share, compared to $56.1 million or $0.63 per share from the prior quarter.

Total net expenses for the third quarter was $51 million, compared to $48.1 million in the prior quarter. As you may recall, we have instituted an incentive fee cap associated with realized capital gains and losses over a trailing period. With the restructuring on Matrix Parent, we were limited to our total amount of incentive fees earned, which we believe highlights a strong alignment of interest between us and our shareholders. For the third quarter, the net change in unrealized gains was $5.4 million, which includes the reversal of the unrealized depreciation from the restructuring of Matrix Parent, offset by net realized losses of $11 million. As of September 30th, total assets were $3.8 billion and total net assets was $1.85 billion. Our ending NAV per share for the third quarter remained unchanged at $20.83.

At the end of the third quarter, our debt-to-equity ratio was 0.99 times, compared to 0.90 times as of the previous quarter, which was driven by our continued deployment throughout this year. As of September 30th, approximately 57% of our funded debt was in the form of unsecured notes, with well laddered maturities ranging from 2025 to 2029. During the quarter, we executed an extension and repricing of our BNP facility from S 2.85% to S 2.25%. We continue to remain pleased with our debt capital stack and will continue to strategically evaluate opportunities to further diversify our sources of leverage. Focusing now on our distributions, our Board of Directors declared a regular distribution for the fourth quarter of $0.50 per share to shareholders of record on December 31, 2024.

Our estimated spillover net investment income is $69 million or $0.77, which continues to provide stability for a consistent regular distribution in a potential decline in rate environment. And lastly, our second $0.10 special dividend that Jeff mentioned earlier will be paid in January 2025. With that, Operator, please open the line for questions.

Operator: Thank you. [Operator Instructions] And the first question today comes from Sean-Paul Adams with Raymond James.

Q&A Session

Sean-Paul Adams: Hey, guys. Good morning. Regarding the activity outlook, what are your guys’ thoughts towards originations for 2025? Do you think it’s going to be front-end loaded in the first half or a little bit lumpy with, it kind of picking up towards the fourth quarter of 2025?

Jeff Levin: Yeah. This is Jeff. Great question and thank you for it. I’d say really hard to predict. The deal flow can be somewhat lumpy in any given calendar year. I think there’s natural tailwinds now to deal flow in general with regards to a little bit more clarity regarding the rate environment with rates coming down. But the election now behind us, and then just the shot clock that exists within private equity capital, right, with every passing quarter, there’s one quarter less that private equity firms have to invest and I don’t believe that they will end up returning the capital to their LPs. I think they will find ways to invest it. Of course, the bid-ask spread between buyers and sellers needs to narrow for us to see deal flow pick up pretty meaningfully.

But I do believe that 2025 will be a better year. Like I said, hard to predict. Pipelines are better than they were, say, earlier in 2024, but there’s just so much money sitting on the sideline right now that I do think will be invested, which is a great tailwind for 2025 and both 2026 as well, I think. But I think also, if you look at our at least the first three quarters of this year, in light of a market where LBO volumes were quite modest, we really didn’t have an issue finding really good ways to deploy capital without stretching on risk and I think that speaks to the quality of not just our direct origination team within our business. And so as a reminder, we have about 75 people dedicated to private credit in the U.S. here with a meaningful subset of that focused on deal sourcing.

But also, we’re a direct beneficiary of the fact that, there is no other direct lending investment business within Morgan Stanley in the U.S. It’s just us. And so the way we collaborate with the institution to optimize deal flow and then be really selective in terms of how we invest, we are firm believers that because of the size of our institution, we’re getting the benefit of a lot more origination power than effectively anyone else in the private credit space in the U.S. And so we feel really good about, obviously, the first three quarters of the year deploying capital, despite the backdrop of LBO volume being down and good tailwinds for the future. I also think the sheer size of our portfolio with across our platform upwards of close to 300 names now is very helpful as those businesses either trade from sponsor-to-sponsor as volume picks up or as companies — portfolio companies or sponsors need incremental financing for bolt-on acquisitions.

So hopefully, that’s helpful.

Sean-Paul Adams: Thank you for all that clarity and I appreciate you going into such deep detail. I appreciate it. Thank you.

Operator: And our next question will come from Melissa Wedel with JP Morgan.

Melissa Wedel: Good morning. Thanks for taking my questions. I wanted to just start with the portfolio yield. Certainly, it looks like that moved a bit lower, certainly more than base rates would sort of drive organically. I’m wondering if you’re seeing sort of elevated refinancing in the portfolio and if that’s how you’re approaching those opportunities and what outlook you have on the refinancing landscape going forward? Thank you.

Jeff Levin: Yeah. Sure. It’s Jeff. I’ll start and then maybe Dave, I’ll hand it over to you. And thanks for the question, Melissa. I think the, in general, I’d say, the backdrop on just the market right now is, just to give you a sense, it does feel like, so the repricing activity has definitely slowed and we saw that quarter over quarter from Q3 versus Q2, which is good, obviously. And then I also think there was a period in 2024 where it felt like spreads were getting tighter, started to see more deals get done at the 4.75 level, some deals getting done at 4.50. It feels like that tightening has really subsided as well. And we’re in more of a SOFR plus 500 or so market today. TBD would spread due over the course of the year — over the course of the rest of this year into next year, given what is expected to happen with SOFR.

But I think in terms of the pressure on new deal spreads and re-pricings, that does feel like it’s subsided quite a bit. And Dave, maybe provide some color in terms of how we, in terms of the yield compression in the portfolio.

David Pessah: Yes. So our yield quarter-over-quarter went down 60 basis points. Majority of that was due to what Jeff just alluded to before, the impact of repricing of deals and incrementals, and then also the impact of the rate cut of 50 basis points within the quarter.

Melissa Wedel: Okay. You mentioned the spillover income as well. That’s always helpful to get an update on. So thank you for that. Going forward, I think, there’s a lot of debate around what the interest rate environment will be and how quickly rates decline and what magnitude. But it does seem like you are well situated to continue out earning that base dividend. As you head into 2025, how are you thinking about excess earnings and dividend policy? Thank you.

David Pessah: Yeah. And thank you for the question. As quickly, just our base dividends remain well covered, as you mentioned. It was 132% coverage for the given quarter. I mentioned on the script, it was $0.77 of spillover. We do have that $0.10 special dividend from the IPO in the current — in the fourth quarter. So it’s really spillover about $0.67. We look to maintain around like one quarters — one full quarters worth of spillover. And given our levels today, I think this provides us with cushion to navigate, as you mentioned, the rate environment ahead. It really depends on the velocity of rate decreases and we’ll assess the need for supplemental dividends headed into 2025. All in all, I think that provides us with a continuous stability going forward of our core dividend of $0.50.

Melissa Wedel: Thank you.

Operator: [Operator Instructions] And our next question will come from Paul Johnson with KBW.

Paul Johnson: Yeah. Thanks. Good morning. Thanks for taking my questions. So just curious, how has LTV ratios leveraged? How has that trended in any of the new deals that you’ve seen? Maybe kind of putting repricing aside versus kind of what’s in the pipeline. Have LTVs remained pretty low as they’ve been or have you started to see that creep up?

Jeff Levin: Yeah. Great question. I’d say it’s been quite stable. We haven’t seen all that much movement over the — quarter-over-quarter in terms of LTVs and leverage ratios. I think, what’s been happening is, in the LBO market at least, it feels like it’s been, I’ll call it, flight to quality. So good businesses have been trading for very full enterprise values. So LTVs continue to be quite modest. So I think, as we underwrite credit now, and I think this applies to the competitive landscape as well, it’s with a real eye towards conservatism in terms of how much debt to put on these companies, because it’s eyes wide open now versus a few years ago when rates were zero. I don’t think anybody expected rates to spike to 5%.

We all run downside case models, of course, that assume a spike in interest rates to make sure the companies can support the debt. But in this environment, given what we saw rates do and rates continue to be high, even if the SOFR curve, the forward curve is accurate, we’re still going to be in an elevated SOFR environment relative to the last several years. And so we’re really conservative at the asset level in terms of our selection and how we structure these businesses. But I’d say not much movement. I’d say the LTV continues to be around 40% on average. I’d say the goal posts are anywhere between 25% and 50%, but the vast majority of deals are hovering around that 40% or so, and the enterprise value multiples continues to be very full.

Paul Johnson: Thanks for that. I appreciate the answer. That’s all for me.

Operator: [Operator Instructions] And our next question comes from Kenneth Lee with RBC Capital Markets.

Kenneth Lee: Hey. Good morning. Thanks for taking my question. Just in terms of your near-term outlook for potential originations, what are you seeing in your pipeline? Any particular attractive sectors that you’re looking at there and could you see some shifts in terms of your sector allocation within your portfolio? Thanks.

Jeff Levin: Sure. Thanks for the question. The — as I mentioned earlier, the pipelines feel better today than they did several months ago. Always hard to predict how much volume closes in any given quarter. We really never think about the business that way, right? We originate the best of our ability. We conduct the best diligence we can. And we deploy capital into what we think are the best situations in the market that are available to us. And the — we’re pleased, as mentioned, with how we got to the leverage target a few quarters post-IPO as we had advertised we thought we could. And again, we did that in an environment where LBO volumes were down, and we continue to be really selective. So we feel good about, the LBO market coming back, even if it doesn’t.

I’m not concerned about our ability to deploy capital really well in 2024. I think it illustrates that, the strength of our sourcing platform. So we feel good about the deployment. What does Q4 look like in terms of volume relative to Q3 or Q2? Only time will tell. Too early in the quarter to predict what that looks like. But we’re pleased with the, most importantly, the health of this portfolio. We’re really happy with the asset composition here, the sectors that were long. Obviously, that was by distinct design and we’re monitoring these portfolio companies extraordinarily closely. I think, generally speaking, as rates coming down, that means there will be more cash flow generation at the borrower level, which is helpful. In terms of sectors, we obviously use the information within our existing portfolio and information more broadly across the Morgan Stanley ecosystem, whether that be what we’re seeing, across the sell side of the firm, within our private equity business, et cetera.

So there’s a lot of content here that we use as we invest money and monitor our portfolios. And as a reminder, we — and we have historically and will continue to steer clear of the sectors that we deem to be more cyclical. So retail, restaurants, energy, those are the sectors that we generally don’t invest in, and I don’t envision that changing. We’ve avoided, generally speaking, businesses where there’s significant reimbursable risk within the healthcare sector as well. So the plans for the future, I wouldn’t say are much different than the past. The two sectors where the longest are software and insurance brokerage. Both those sectors are performing really well. And I’d say the logistics sector is a space where we’ve seen increased softness, and so that’s a sector that we, I would say, our foot is more on the brakes than gas there for sure.

But all in all, we’ll continue to invest this money on a very diversified basis, both at the borrower level, by industry sector, trying to play defense as it relates to the sectors that we are lending into. And obviously very selective on the borrower side and then also as it relates to which sponsors we’re financing their businesses as well. And so hopefully that’s helpful, Ken.

Kenneth Lee: Yes. That’s a very helpful color there. And just one follow-up, if I may, any updated thoughts around the relative attractiveness between upper middle-market or core middle-market segment for originations over the near-term, especially given the competitive landscape there? Thanks.

Jeff Levin: Yeah. That’s a great question. So, we cover 400 sponsors within our business alone. We have New York, Chicago, LA offices, senior layer of the investment team has been in this business for 20-plus years. So there’s a lot of existing and incumbent knowledge within our investment committee. A lot of the deals in our book and ones that come through that either we do or we pass on, we’ve seen in some cases multiple times throughout the course of our career. The — if you look at our portfolio, generally, there’s roughly half the deals are above 100 of EBITDA and half are below. And I think when you look at the sponsors that we cover from our team, and then you layer on the sell side of the firm here, the reach is what we think is really best in class.

And that allows us, frankly, to go way up market when the opportunity is really interesting, and then go into the core middle market when we think the risk return is really attractive there as well. So, for example, in 2023, when the syndicated loan market was closed, there were businesses, $200 million, $300 million, $400 million, $500 million in EBITDA that were coming to the private credit market, offering really good risk adjusted return, really diversified companies with great management teams with enormous value below us. And so we deployed capital into some of those situations. In 2024, given the health of the syndicated loan market, there are fewer jumbo unitranche deals for obvious reasons. And so we’ve been investing in the core end of the middle market.

So I would define that as on the low end 30 to 40, upwards of call it $100 million, $125 million of EBITDA and we’ve had really no issue deploying capital. I think the risk return, though, and the attractiveness of it really varies depending on the market environment that we’re in. And so, I’d say, generally speaking, the companies at the lowest end of the EBITDA range, sub-25 of EBITDA, we generally don’t lend to those size businesses. I find those companies are just more fragile. The management teams, in some cases, just aren’t as sophisticated and there’s more customer concentration and supplier concentration in those types of companies. And so in the spread premium there, I also don’t think is that compelling because there’s so many lenders in the private credit space that can underwrite and hold a lower middle market deal and so I find the supply dynamic — the supple-demand dynamic there is not as compelling.

So we’re going to continue to move up and down the size spectrum based on where we see value. And that’s a combination of the strength of the underlying company, the capital structure being proposed, the strength of the covenant package as well, both financial covenants and negative covenants and so it’s the full picture. But that’s one thing that I really like about our strategy, is that we have the flexibility and the origination capability to go up and down the size spectrum based on where we see value.

Kenneth Lee: Great. That’s a very helpful color there. Thanks again.

Jeff Levin: Thank you.

Operator: At this time, I’d like to turn the call back to Jeff Levin for closing remarks.

Jeff Levin: Thank you. On behalf of the management team, I greatly appreciate you joining us today along with your support of Morgan Stanley Direct Lending Fund. Our team remains focused on executing our defensive investment strategy to drive shareholder value and I couldn’t be more pleased with our continued execution. We’re well positioned to capitalize on any market environment due to our sourcing advantages and unique credit platform. We look forward to providing an update on our fourth quarter 2024 earnings call in February. Thank you.

Operator: Thank you. That does conclude today’s conference. We do thank you for your participation. Have an excellent day.