Morgan Stanley Direct Lending Fund (MSDL) 2024 Q2 法說會逐字稿

Welcome to the Morgan Stanley Direct Lending Fund second-quarter 2024 earnings call. (Operator Instructions) As a reminder, this conference call is being recorded.

At this time, I'd like to turn the call over to Mr. Michael Occi, Head of Investor Relations and Chief Administrative Officer. Please go ahead.

Good morning and welcome to Morgan Stanley Direct Lending Fund's second-quarter 2024 earnings call. Joining me 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 second-quarter 2024 financial results were released yesterday after market close 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 Mortgage 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, uncertainties surrounding rising interest rates, changing economic conditions, and other factors we have identified in our filings with the SEC.

Although we believe that these 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 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.

Thank you, Michael, and thank you for joining us today for Morgan Stanley Direct Lending's second-quarter 2024 conference call. We are proud of the strong results that we generated during the second quarter. I'll first begin with an overview of our second-quarter 2024 performance 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 second quarter supported by strong credit performance. Net asset value per share increased by $0.16 to $20.83 per share and we generated net investment income of $0.63 per share consistent with the first-quarter results and well in excess of the $0.50 per share regular dividend we declared for the quarter.

For the second quarter, new investment commitments totaled approximately $673.9 million in 46 portfolio companies. Net funded deployment for the quarter was $210 million as compared with $97 million in the first quarter. We remain confident in our ability to deploy our excess capital, and the second=quarter results are evidence of that. During the quarter, MSDL's debt to NAV increased to 0.9 times from 0.81 times. And given the strength of our origination platform, we expect to achieve our target leverage of 1 to 1.25 in the second half of the year without stretching on credit.

We demonstrated another strong quarter of driving quality originations through our investment framework, leading or co-leading 100% of the new borrowers added to our portfolio in the second quarter. In our view, these deals were favorable from a credit perspective when you consider the leverage and loan-to-value profiles, among other attributes. We believe we have differentiated ourselves in the direct lending ecosystem, with the power of the Morgan Stanley brand driving performance through both scale and longstanding partnerships.

Sponsors are drawn to the quality of our team and our ability to be a value-added partner given the broad platform we are a part of. Our top priority is delivering shareholder value. We're confident that our combination of relatively low expenses, a thoughtful fee structure, and our defensive investment strategy will continue to deliver value to our shareholders in the coming quarters.

Turning now to market outlook. Resilience defined the first half of 2024, marked by economic outperformance against the backdrop of a potential soft landing and anticipated policy easing. Clearly, some of that narrative has been up for debate over the past week as the market evaluates the economic trajectory. That being said, the risk appetite for private credit as an asset class remains strong with highly attractive returns and downside protection. Gross asset yields have persisted at elevated levels and credit performance has been solid. Deal flow has been resilient and we continue to believe it is poised to accelerate.

Regarding deal activity, we view the capital market rebound as on track, with sponsor M&A likely to accelerate. Recent market activity serves as a reminder that this is not likely to happen in a straight line. However, we see a growing desire for private equity firms and other asset owners to transact due to LP dynamics in generally more conducive private and public financing markets. Net net, we expect that sponsors are likely to deploy capital, which we believe will create lending opportunities for us.

It's important to note that both the direct and public lending markets will continue to co-exist. We believe Morgan Stanley Direct Lending's nimble approach to investing up and down the side spectrum enhances our ability to find attractive lending opportunities in an always-changing market, while remaining selective, positioning us well to capitalize on quality opportunities for the foreseeable future.

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.

Thank you, Jeff. Starting with our portfolio, we ended the second quarter with a total portfolio at fair value of $3.5 billion, which was comprised of 95% first-lien debt, 3% second-lien debt, and then the remainder in equity and other investments.

As of June 30, we had investments in 192 portfolio companies spanning across 34 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 15.7% and 14.3% of the portfolio at fair value, respectively. The average position size of our investments was approximately $18.3 million, or 0.5% of our portfolio on a fair value basis. Further, our top 10 portfolio companies represented approximately 18% at fair value of the total portfolio.

At the end of the second quarter, our weighted average loan-to-value was approximately 40% and the weighted average EBITDA of our portfolio companies was $150 million. Additionally, the median EBITDA of our portfolio companies was approximately $82 million. As of June 30, our weighted average yield on debt and income-producing investment was 11.7% at fair value and 11.6% at cost.

With respect to our internal risk ratings, as of June 30, over 98% of our total portfolio had an internal risk rating of two or better, which is unchanged relative to the first quarter. Additionally, the investments on non-accrual totaled approximately $12.4 million, representing 30 basis points of the total portfolio at cost. For our investment activity in the second quarter, we made new investment commitments of approximately $674 million in 22 new portfolio companies and 24 existing portfolio companies across 22 industries. Investment fundings totaled $499.7 million, with $289.3 million in repayments, which included full repayments from eight portfolio companies for net funded investment activity of $210.4 million.

Turning to our financial results for the second quarter. Our total investment income was $104.2 million for the second quarter as compared to $99.1 million in the prior quarter. The increase was driven by recurring interest income from deployment and repayment-related income. PIK income continues to remain relatively low, amounted to only 3% of total investment income.

Net investment income for the second quarter was $56.1 million or $0.63 per share compared to $54.7 million or $0.63 per share from the prior quarter. Total expenses for the second quarter were $48.1 million compared to $44.5 million in the prior quarter. As a reminder, we have instituted a partial waiver of our management and income-based incentive fees in connection with our IPO through January 24, 2025. For the second quarter, the net change in unrealized gains was $2.8 million.

As of June 30, total assets were $3.7 billion and total net assets were $1.9 billion. Our ended NAV per share for the second quarter increased to $20.83 compared to $20.67 at the end of the first quarter. At the end of the second quarter, our debt-to-equity ratio was 0.9 times compared to 0.81 times as of March 31, 2024, which was driven by our funded deployment this quarter and will continue to trend upward into our target leverage range. As of June 30, approximately 63% of our front-end debt was in the form of unsecured notes with well-laddered maturities ranging from 2025 to 2029.

During the quarter, we closed an offering of $350 million aggregate principal amount of unsecured notes due in 2029, which bear a fixed coupon of 6.15%. In connection with our note offering, we swapped the issue to floating. Also, as we discussed last call, we executed an extension of our secured revolving credit facility from January 2028 to April 2029, increasing our total commitments to $1.3 billion while preserving our attractive pricing. We continue to remain pleased with our debt capital stack and will continue to strategically evaluate opportunities to further diversify our sources of leverage.

Last, our Board of Directors declared a regular distribution for the third quarter of $0.50 per share to shareholders of record on September 30, 2024. Our estimated spillover net investment income is $63.5 million or $0.71 on a per-share basis, which provides continued stability for a consistent regular distribution. As a reminder, in connection with our IPO earlier this year, our Board of Directors also declared two $0.10 special dividends to be paid in October 2024 and January 2025, respectively.

With that, operator, please open the line for questions.

(Operator Instructions) Sean-Paul Adams, Raymond James.

You currently have a high level of portfolio overlap with a number of large BDCs in the space. How long do you think it will take to rotate into more unique, non-overlapping positions?

Yeah, it's Jeff. Thanks for the question. Look, I think we benefit from -- in our opinion, granted we're biased -- the most unique and differentiated origination platform in the market. So if you see overlap within our portfolio and others, that's based on our investment strategy, which really is focusing on investing in the highest quality opportunities that we originate.

And most of the deals come through our direct origination team that's dedicated to our private credit business within the investment management platform. We do work in close coordination in certain instances with the sell side of the firm. So the investment banking division, the capital markets team within Morgan Stanley, to further expand the tentacles that we have into the private equity ecosystem and find ways to lead and co-lead, again, the highest quality opportunities. And so as we mentioned earlier, all the deals that we did in the quarter that were new logos into our portfolio in the second quarter, we led or co-led all of the deals.

So we're directly originating all these situations. Private equity firms, as you probably know, they club these deals up as well. So they want to diversify their funding sources based on their financing needs, both at close and then ongoing as they look to grow, generally with an acquisition strategy. So again, we're less focused in terms of what the overlap looks like with other BDCs and really focused on widening out our origination footprint as best as possible and then sifting through that opportunity set, investing in what we deem to be the highest quality opportunities that we can find.

Melissa Wedel, JP Morgan.

I wanted to touch quickly on your comments about acceleration of, I think, the originations environment into the second half. I apologize if I missed it, but did you mention what your expectations are in terms of repayments as well? Should we be thinking about a lot of refi happening in the second half?

Yeah. Hi, it's Jeff. Thanks for the question. Predicting repayments, of course, is always hard to do. Repricing and repayments has picked up, as you saw in the quarter relative to prior quarters. Gross originations, as you saw, picked up quite a bit in the second quarter as well, with close to $700 million of gross originations, about two-thirds of which was truly new capital being deployed.

Really hard to know how that plays out over the course of the year. The markets, as you know, have presented some volatility over the last week or so. So we'll see how that plays out and what that means for private credit and LBO activity in the spread environment over time. We continue to be focused, frankly, on optimizing our deployment in terms of the highest quality deals that we can invest in and monitoring our portfolio really closely.

And so I think, Melissa, the second quarter we feel really good about with regards to the capital that we deployed. Obviously, increasing leverage a bit from Q1 to Q2 with an eye towards the target leverage by the end of the year, as I mentioned before. What's in our control clearly is how we deploy capital. And we continue to really focus on doing that very cautiously, given the macroeconomic uncertainty that exists.

The repayments are less in our control, frankly. But repayments and repricings also, there's a positive there as well because it gives us an opportunity to bow out of certain situations that we may want to, and that could be based on structure, pricing, whatever it may be. But hard to predict what the back half of the year looks like in terms of repayments.

(Operator Instructions) Kenneth Lee, RBC.

Just wondering whether you could just flesh out some thoughts around relative exactness of either the upper middle market or middle market segments for potential originations over the near term, just given what you're seeing right now. Thanks.

Sure. Thanks for the question. When you look at our deal flow, it really does span up and down the size spectrum. And so we have the origination team, as I mentioned earlier, dedicated to our direct lending business. And then obviously, the reach of the institution, more broadly within the investment banking division and the capital markets division, fixed income, and so on and so forth, I think really equips us with the opportunity set all the way up and down market.

And so, roughly half the deals in the portfolio above [100] EBITDA, roughly half below median EBITDA in the book, generally has been between $60 million, $65 million or so when we put money in the ground initially, so at close of a transaction. And then the median has ticked up to be over $80 million, because these businesses have performed well, growing both organically and organically. And I should mention we continue to see that in the second quarter. So the health of this portfolio we continue to feel really good about. As you can probably note in the materials, the non-accrual rate continues to be extremely low.

In terms of the opportunity set up and down market, though, it varies. Last year in 2023, when the syndicated loan market was closed or generally closed, much larger companies were coming to the private credit market because that was the source of open financing. And we and our competitors, frankly, were able to monetize that. The current market with the syndicated loan space is in a much healthier place. Larger companies have opportunities to go to the private and public markets, and that's typical. Last year was an outlier, frankly.

And so our deployment in the second quarter, frankly, it looked pretty much in line with our historical averages of our capital deployment in terms of weighted average EBITDA and median EBITDA and the like. Leverage on new deals did tick down a bit. And so the leverage across the portfolio did come down a touch, which is great. Loan-to-value was pretty modest as well, below historical averages. So the loan-to-value in the quarter on new money deployed was in the low 30s percentage. So enormous enterprise value below us.

I tell you today, I wouldn't say that I would favor one segment of the market over the other. Every situation is completely unique. We don't invest much below, call it, $25 million or $30 million of EBITDA, and that's just based on businesses being a bit more fragile. Companies just lack the scale and diversification of customers and suppliers. So we generally skew above that threshold, as I mentioned, meeting EBITDA in the book today, just over $80 million.

But every deal structure completely bespoke in terms of analyzing the quality of the cash flows, the management team, the amount of equity behind us, the quality of the equity as well. So who's the sponsor, who's the partner, what's their track record like, what's the growth strategy, how much risk is the equity sponsor going to take to accomplish their goals and objectives. The covenant package as well, obviously, both financial covenants and nonfinancial covenants within the document, the industry sector. So a lot goes into how we think about deploying capital.

And at the low end of the market, today, there's not, in my opinion, that much of a spread premium relative to what I'd call the core and upper middle market. And part of that is just supply and demand. If you go down to credit facilities of $1 million to $100 million, there's so many direct lenders that can underwrite and hold those facilities. So there's competition there. And so, again, it's really bespoke to the situation.

I wouldn't generalize and say we like the lower middle or upper end of the market today more than the other. It really varies. I think LBO volume, as you know, in the first half of the year was relatively muted relative to historical averages. We do think that that'll change over time, just given the amount of dry powder within the private equity world. As I mentioned, it won't be a straight line. The markets have been somewhat volatile over the last week or so, as you know, so we'll see how that plays out over the course of the year.

But if you put on your, call it, 12- or 18-month hat, barring some significant market dislocation, we do think that LBO volume will pick up, which is going to further facilitate deal flow for us in the market. But we feel great about our market positioning. We'll continue to invest up and down the size spectrum based on where we see value, and again, monitor our portfolio extremely closely to preserve the value of the money that we have in the ground.

So sorry to be long-winded, Ken, but hopefully that color is helpful.

No. That is super helpful. That is super helpful. And on that last point there, in terms of the conversations you've been having with PE sponsors and looking to your pipeline there, is there any specifics that's giving you confidence for potential pickup in potential M&A activity in the second half there? Thanks.

Yeah. Nothing overly specific. This is no secret. Limited partners want their money back. So there's a force there. We saw a pickup in continuation fund deals over the last 12 or so months. I'd say that trend appears [have] cooled off a bit. Unclear exactly why. But I think just the sheer fact of the amount of dry powder sitting within the private equity world, coupled with the fact that LPs are eager to have their capital back, those forces, I think, will drive a narrower delta between buyers and sellers.

The deals that we have done, as I mentioned, multiples continue to be quite high. And so that's been great for us as lenders sitting at the top of the capital stack with a mountain of value below us. Again, just insulating our loans from a lot of downside protection. But nothing overly specific in terms of why we think markets will come back.

I think, generally speaking, except for late last week and early this week, the financing markets have been extremely strong. So that naturally facilitates activity. We did see, as noted in the numbers, our Q2 was quite a bit more active than the first quarter. So we did see an uptick in activity, which is good. And generally speaking, we think that's going to continue.

(Operator Instructions) Paul Johnson, KBW.

(technical difficulty) Yeah, sorry about that. Anyways, I was just asking about, roughly, can you let us know kind of what percent of originations are in the BDC just across the overall Morgan Stanley Direct Lending platform?

Yeah, sure. I don't think we disclose the specifics. We have an extremely robust allocation policy that governs how we allocate deals. So we have several pools of capital in both BDC and non-BDC format as part of our capital base that we have exemptive relief with the SEC to co-invest across these funds. And so in my opinion, each pool of capital is a significant asset to one another and the shareholders and LPs across the investor base. And the investor base here across our business is extremely diversified and global in nature with some of the most sophisticated institutions in the world allocating capital to us. So it's very sticky stable money across the business here.

But in terms of the percentage of the deals that get allocated to this vehicle, effectively all the deals that we do get allocated across all the funds, assuming there's available capital. And there's several layers of oversight in terms of how we allocate the deals, these allocation committees, and it flows up through our investment committee and so on and so forth. And we have a majority independent Board of Directors, as you're probably familiar with.

So long story short, we have an allocation policy that governs how it works. Generally speaking, it's based on available capital. And there's somewhat of a bespoke nature to it, though, in that if one pool of capital is very late in its investment period and doesn't have much capital left, that pool of capital will receive a smaller allocation of the deal.

Or let's say that pool of capital, based on the investment objectives, is looking at deals only of a certain size or leverage threshold or is already getting close to a limit in terms of an industry concentration, that could also impact how we allocate these deals. But this pool of capital, again, is getting allocated across effectively everything that we do. It will vary in size in terms of what percentage of each deal gets allocated to this fund based on a number of factors, as I just mentioned. So hopefully that's helpful.

Yes, that is. Thanks for that. And then on new originations that you guys are doing now, sort of what level -- are you guys getting call protection on those new investments? And kind of what level of call protection do you get these days? Is it two years, three years? Where is the market at?

Yeah, so it varies deal by deal. Generally speaking, we're investing in the top of the capital structure, the lowest risk part of the capital structure. And so, usually it's roughly one year of protection at [101]. There's outliers, of course, on both sides. But generally speaking, again, we're skewing towards the very top of the capital stack with 30% to 40% or so loan to value. In this past quarter, was at the low end of that range. The weighted average across the book is just over 40%.

And so, call protection is something that, I would say, is gravy if and when it happens. When we underwrite to our returns, we're not underwriting to prepayment penalties. The format of our return profile is really all contractual via SOFR Plus spread plus OID or commitment fees upfront or admin agent fees.

I should note that, unlike maybe some other players in the space, 100% of any income that we generate associated with our capital deployed. So whether that would be everything that I just said, it all flows through the vehicles. So we're not trapping any of the income or fee generation or anything at the adviser level. It all flows through to the benefit of the shareholder base.

And there are no additional questions at this time. I will now turn the call back to Jeff Levin for closing remarks.

Thank you. On behalf of the management team, I greatly appreciate you joining us today along with your support of the 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 progress to date. We are well positioned to capitalize in any market environment due to our sourcing advantages and unique credit platform, and we look forward to providing an update on our third-quarter 2024 earnings call in November. Thanks.

This concludes today's call. Thank you for your participation. You may now disconnect.