Earnings Call Transcript - MSDL Q1 2024

Operator, Operator

Welcome to Morgan Stanley’s Direct Lending Fund’s First 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, Head of Investor Relations and Chief Administrative Officer

Good morning. And welcome to Morgan Stanley Direct Lending Fund’s first quarter 2024 earnings call. Joining me are Jeff Levin, President and Chief Executive Officer; David Pessah, Chief Financial Officer; Orit Mizrachi, Chief Operating Officer; and Rebecca Shaoul, Head of Portfolio Management. Morgan Stanley Direct Lending Fund’s first quarter 2024 financial results were released yesterday after market closing and can be accessed on the Investor Relations website. 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, uncertainties surrounding rising 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 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, President and Chief Executive Officer

Thank you, Michael, and thank you for joining us today for Morgan Stanley Direct Lending’s first quarter 2024 conference call. We are proud of the strong results that we generated during the first quarter, our first as a public company. We completed our IPO in January, and I’d like to welcome our existing and new shareholders, as well as members of the investment community who have been following the Morgan Stanley Direct Lending Fund story. I’ll first begin with an overview of our first quarter 2024 results before discussing our market outlook. Dave will then provide updates on our portfolio and comments on the financial results. Our team delivered solid operating results for the first quarter, supported by continued strong credit performance. The quarter-end net asset value per share was unchanged from the prior quarter, despite the dilution from the IPO and being comfortably below target leverage. We generated net investment income per share well in excess of the $0.50 per share dividend that we declared for the quarter. For the first quarter, new investment commitments totaled approximately $232 million in 30 portfolio companies. We remain confident in our ability to reestablish leverage back within our target range over the coming quarters, as previously communicated during our last earnings call. I would also highlight that we believe the quality of our origination activity remained high, and we served as the lead or joint lead arranger on about 80% of Morgan Stanley direct Lending new platform originations during the first quarter. We believe this showcases our ever-increasing presence in the marketplace and private equity firms’ preference for us as a partner. We believe sponsors want to work with us, not just because of the extensive experience of our investment team, but also due to the strategic benefits that come with partnering with Morgan Stanley and that this structure is unique in the direct lending ecosystem and will continue to differentiate us as investors. We continue to be highly focused on delivering value for our shareholders. We believe that the combination of relatively low expenses, a thoughtful fee structure, and our defensive investment strategy will help drive shareholder value. Turning now to the market outlook, we believe that the direct lending market environment remains highly attractive, providing strong, risk-adjusted returns for our investors. Gross asset yields remain elevated, and credit has continued to perform well. Yield flow has been resilient, and we believe is poised to accelerate. Year-to-date, we’ve generally witnessed a continuation of the risk-on tone that emerged in late 2023, driven by a more reassuring economic outlook and signals that the Fed may shift course. While those interest rate cuts may now be delayed, we believe the prevailing economic trends persist. The U.S. economy has been resilient throughout this inflationary environment. We think the strong performance of our middle-market borrower base is an extension of that in terms of the ability to withstand elevated interest costs that are accruing to the benefit of our investors. We are not complacent about the ongoing geopolitical and macroeconomic uncertainty, but we like our defensive positioning in the market, focused at the top of the capital structure, in avoiding the deeply cyclicals. Regarding deal activity, we expressed confidence on our last earnings call that we will see increased deal volumes with visible green shoots in the M&A market as the year progresses. While financing volumes for new middle-market leverage buyouts remain subdued in the first quarter, pipelines are starting to build, and we remain optimistic that activity may accelerate with more visibility on the trajectory for interest rates. Private equity sponsors are sitting on record levels of dry powder, and they are motivated to put that capital to work. The fact that debt financing is abundant as well, both in terms of private debt capital, as well as due to the function of the broadly syndicated loan market, could serve as another catalyst to help jumpstart sponsor-related M&A activity. We believe our nimble lending approach to borrowers up and down the size spectrum enhances our ability to continue to capitalize on opportunities as they present themselves in the coming quarters. 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, Chief Financial Officer

Thank you, Jeff. Starting with our portfolio, we ended the first quarter with a total portfolio at fair value of $3.3 billion, which was comprised of 95% first-lien debt, 4% second-lien debt, and the remainder in equity and other investments. As of March 31st, we had investments in 170 portfolio companies spanning across 31 industries, with nearly 100% of our investments in floating rate debt. Our two largest industry exposures remain in insurance services and software, which accounted for 15.1% and 14.8% of the portfolio at fair value, respectively. The average position size of our investments was approximately $18.5 million or 0.6% of our total portfolio on a fair value basis. Further, our top 10 portfolio companies represented approximately 20% at fair value of the total portfolio. We believe that our portfolio diversification, included by loan size and industry, is a significant risk mitigation tool that is further insulated by the fact that we look to maintain diversity by selectively targeting non-cyclical industries while preserving low borrower concentration. At the end of the first quarter, our weighted average loan-to-value was 43%, and the weighted average EBITDA of our portfolio companies was $155 million. Additionally, the median EBITDA of our portfolio companies was $82 million. As of March 31st, our weighted average yield on debt and income-producing investments was 12% at fair value and 11.9% at cost. With respect to our internal risk ratings, as of March 31, 2024, over 98% of our total portfolio had an internal risk rating of 2 or better, which is unchanged relative to the December 31, 2023 period. Additionally, we had three investments on non-accrual status, representing approximately $12.4 million or 40 basis points of the portfolio at cost, which is down from 60 basis points as of December 31, 2023. Of the three investments, there was one new investment placed on non-accrual status, which was a first-lien position in Matrix Parent. Our second-lien tranche in Matrix Parent was placed on non-accrual status last quarter. There was one investment removed from non-accrual status, that being Barnum & Black, which was restructured in the current quarter. For our investment activity in the first quarter, our team made new investment commitments of approximately $232 million in nine new portfolio companies and 21 existing portfolio companies across 14 industries. Investment fundings totaled $168.4 million, with $71.7 million in repayments, which included full repayments from three portfolio companies for net funded investment activity of $96.7 million. Turning to our financial results for the first quarter, our total investment income was $99.1 million for the first quarter, as compared to $100.8 million in the prior quarter. The slight decrease was driven by a reduction in non-recurrent repayment-related income. PIK income continues to remain relatively low, amounting to only 3% of total investment income. Net investment income for the first quarter was $54.7 million or $0.63 per share, compared to $55.5 million or $0.67 per share from the prior quarter. Total expenses for the first quarter of 2024 were $44.5 million, compared to $45.3 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, commencing on January 24, 2024, through January 24, 2025. For the first quarter ended March 31, 2024, the net change in unrealized gains was $2.7 million, offset by realized losses of $5.6 million. The realized losses for the period was the result of three portfolio companies that were restructured during the period. At the end of March 31st, total assets were $3.4 billion and total net assets was $1.8 billion. Our ending NAV per share for the first quarter remained unchanged at $20.67. Our core earnings in excess of our dividend fully offset the dilution from our IPO and unrealized and realized activity. Our supplemental materials for this call provide a full quarter-over-quarter NAV bridge that illustrates these changes. At the end of the first quarter, our debt-to-equity ratio was 0.81 times, compared to 0.87 times as of December 31, 2023. In conjunction with our IPO, the initial proceeds were used to pay down a portion of our existing debt obligations. With our available dry powder, we plan to remain active in the current investment environment and expect to achieve our target leverage of 1 times to 1.25 times over the coming quarters, although that likely won’t be linear. As of March 31, approximately 47% of our funded debt was in the form of unsecured notes, with well-laddered maturities ranging from 2025 to 2027. Subsequent to quarter end, our available liquidity was further enhanced as we successfully executed an extension of our secured revolving credit facility from January 2028 to April 2029, increasing our total commitments for $1.12 billion to $1.3 billion by maintaining and growing our financing relationships, all while preserving our attractive pricing. We 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 second quarter of $0.50 per share to shareholders of record on June 28, 2024, which is consistent with our first quarter 2024 dividend. Our estimated spillover net investment income is $52.1 million or $0.59 on a per share basis, which provides continuous stability for consistent regular distributions. As a reminder, with our IPO earlier this year, our Board of Directors declared two $0.10 special dividends to be paid on October 25, 2024 and January 27, 2025, respectively. With that, Operator, please open the line for questions.

Operator, Operator

Thank you. Let's begin with our first question from Robert Dodd at Raymond James.

Robert Dodd, Analyst

Hi, guys. Congratulations on the quarter. A question, just on the green shoots and hopes for acceleration activity, et cetera. I mean, a lot of these metrics, record dry powder for PE firms, et cetera, I mean, that’s been true for a while. Initial builds in M&A pipelines, I mean, that was true probably this time last year, right? So we’ve heard these things before and it hasn’t manifested so far. So why is your confidence higher now, given that many of the themes have been LPs want capital back as well? That’s been the theme for two years at this point. So why is the confidence higher today?

Jeff Levin, President and Chief Executive Officer

Yeah. Sure. Thanks for the question. This is Jeff. I think it’s a few things. The first would be that the marketplace, private equity, the loan market, the private credit market has now been living in this elevated rate environment for longer. We’ve been living with macroeconomic uncertainty, geopolitical noise as well for a decent period of time now, and businesses, generally speaking, have been performing well across the market. And so I think that, as more time passes, I think that will continue to give private equity owners increased conviction in terms of transacting. How long will there be a relatively wide bid-ask spread, so to speak, in terms of what sellers are looking for, for their existing assets and what buyers are willing to pay? Only time will tell. The clock does tick, of course, on private equity capital. And so as time goes by, those investment periods, they shorten. So I think it’s a confluence of all those factors, Robert. We have seen an uptick in pipelines over the last several weeks. March was a busier month than January and February were. So generally speaking, that’s the trend that we’re seeing real time. In terms of what that ultimately means and how the rest of the year plays out, only time will tell.

Robert Dodd, Analyst

I understand. Thank you. One of the themes that has been consistent over the past year, including this quarter, is significant follow-on activity. The benefit of being an established lender is key here. Is this trend likely to remain high? Are some of these activities driven by your portfolio companies seizing the chance to acquire even more, or do you anticipate a shift in the mix towards more new platform deals over the next 12 months?

Jeff Levin, President and Chief Executive Officer

Yeah. That’s a great question. I think in the absence of LBO volume increasing pretty substantially, I think we will continue to see incremental facility add-ons to fund acquisitions by existing portfolio companies with sponsors as they try and create value with what they have versus paying up for new platforms. So, I do think that trend will continue. Our 200-plus portfolio companies across our private credit platform here obviously is a significant asset to us. The existing portfolio is also an asset to us away from the incremental financings, but also should LBO activity pick up and there be change of control across an increased number of the portfolio, given the origination we have and the reach that we have with the private equity community, both from our dedicated team here of about 60 people dedicated to private credit in the U.S., as well as obviously the broader institution given the reach of the sell side of the firm, notably the financial sponsor coverage group in the leveraged finance business here. We think we’re well positioned in either environment, frankly. The beauty of having a portfolio of that size and scale is these are assets that we know inside and out. And so, there may be certain assets that we want to continue to hold in a change of control environment. There may be certain assets that were great performers over the last three years or four years, but we don’t necessarily think will be a position we want to hold to a contractual six-year or seven-year maturity in the future. And so, getting back to the investment mindset that we have as we deploy capital, we think we’re really well positioned here for those reasons.

Robert Dodd, Analyst

Got it. Appreciate that color. One more, if I can. On the credit quality side, obviously, a lot of technical difficulties down to restructuring, you rated four assets at a zero again now. I mean, credit quality looks really robust. Are there any emerging signs in the portfolio, any industries that you’re incrementally becoming more worried about, because there don’t seem to be a lot of issue industries or credits in the portfolio right now?

Jeff Levin, President and Chief Executive Officer

Yeah. No. I think you’re spot on. Generally speaking, I’d say no. The issues in the portfolio, which, as you’ve probably noted, have been exceptionally few and far between and total dollar quantums have been effectively de minimis, been more idiosyncratic. The two sectors were the longest by design, software and insurance brokers continue to perform really well. As it stands today, we feel really good about the quality of our portfolio. It’s obviously almost entirely first-lien credit risk, loan-to-value 40% to 45%. We’ve avoided the deeply cyclicals intentionally. The book is extraordinarily well diversified, both by company, by sector, by sponsor. So from a credit standpoint, we feel really good about where we are, and we’ll use the dry powder that we have within our financing lines to continue to invest in the deals where we find the optimal risk-adjusted return.

Robert Dodd, Analyst

Got it. Thank you.

Jeff Levin, President and Chief Executive Officer

Thank you.

Operator, Operator

Our next question comes from Melissa Whittle with JPMorgan.

Melissa Whittle, Analyst

Good morning. Thanks for taking my questions today. I wanted to start with, following on some of the things that we’ve heard across the space there. It seems there’s been some proactive repricing on some investments, particularly some outperformers in portfolios where they might have other options as the BSL market has opened up. I’m curious how you’re thinking about that. Are you seeing any of those opportunities in the portfolio? Is that something you’re spending time on?

Jeff Levin, President and Chief Executive Officer

That's a great question. The syndicated loan market has become very strong and poses a significant competitive threat to the larger end of the private credit market. Businesses that can access the syndicated loan market are actively considering what the best options are. I believe private credit will continue to grow over time, regardless of the public credit market's health, for many reasons, including the preferences of businesses of all sizes to use private credit. We definitely saw an increase in repricing volume in Q1, and I expect this trend to continue throughout the year, assuming the public markets remain as strong as they are now or perhaps tighten even more. We are monitoring this closely. Our portfolio is diversified across different sizes, which positions us well against competitors. Many businesses in our portfolio are not suited for the public markets, and those deals are likely to be the most affected by repricing. However, we're observing repricing across the entire size spectrum, mainly leaning towards the larger end of the market. As the year progresses, I anticipate this trend will persist. We're in constant communication with our borrowers and private equity owners regarding these developments. Back in 2023, when the market was deploying capital at SOFR+ 625, 650, and 675, there was a general sense that these terms might not be sustainable if interest rates remained higher for an extended period, which seems to be the consensus now. Even with some tightening of spreads, the overall return profile and yield we can achieve still appear very attractive given the associated risks.

Melissa Whittle, Analyst

That’s helpful. And you touched on my follow-up question, too, which is around spread compression. We’ve definitely heard there’s been more spread compression in the upper middle market in particular where BSL is more of an option, but not necessarily as much spread tightening in sort of the core middle market. As you look across your pipeline and opportunity set, I’m wondering if you’re seeing that as well, if the core middle market opportunities are a little bit more attractive to you in this environment with spreads being where they are. If that’s the case, would that impact, do you think, sort of the scaling of portfolio leverage and how long it takes to sort of get to your target? Thanks so much.

Jeff Levin, President and Chief Executive Officer

Great question. The capital we invested in the first quarter was mostly in line with our overall portfolio characteristics. The weighted average EBITDA was around $100 million, with a median EBITDA in the $60 million range, consistent with our general business trends. Median EBITDA has typically fallen between $60 million and $70 million, and it’s larger now as these businesses have grown. Value opportunities are present across the size spectrum. Our origination footprint includes about 400 buyout funds, allowing us to engage with a diverse range of sponsors. In the first quarter, we worked with sponsors of all sizes, such as Thoma Bravo at the high end and Charles Bank in the core middle market, alongside others like Summit Partners, Harvest Partners, and Vista. One of our platform's strengths is that we’re not limited to just one market segment. Our capital deployment strategy is flexible; we adjust based on where we identify value and risk-return dynamics, tailoring each deal to its specific merits. Generally, our loan-to-value ratios are between 40% and 45%. We led or co-led around 80% of our deals in the quarter, including all the LBOs, reinforcing our leadership position in the market as our private credit business scales. We aim to reach our target leverage over the next few quarters, but I can't say whether it will be in Q2, Q3, or Q4. I’m confident in our capital deployment abilities; our origination engine is very strong. However, we’re committed to investing in high-quality opportunities. It’s important to remember that while it's easy to make loans, getting to target leverage quickly could involve increasing our risk appetite or taking larger positions. We will continue to focus on a defensive strategy, being selective and maintaining appropriate hold sizes. We believe in diversification as an essential risk management strategy. I’m confident we will achieve our target leverage, although the exact timing remains to be seen. Overall, we are pleased with the quality of our portfolio and our ability to deploy capital effectively within the private equity ecosystem.

Melissa Whittle, Analyst

That’s really helpful. Appreciate the information. Thank you.

Operator, Operator

Our next question comes from Paul Johnson with KBW.

Paul Johnson, Analyst

Hey. Good morning. Thanks for taking my question. The one I was going to ask you, you pretty much answered from Melissa’s question, but kind of asking it maybe a little bit different ways, at a high level, you guys are generating 12% ROE with the fee waivers today. I mean, how do you feel about operating leverage even below Arvid and kind of patiently sort of waiting to kind of get up into that range? And I guess, how do you feel about kind of the sense of urgency, I guess, into that range when you’re already generating pretty solid ROE today?

Jeff Levin, President and Chief Executive Officer

Yeah. I’ll go first, and then Dave, feel free to opine as well. We’re not in a rush to do anything, frankly, except monitor the book really closely, work with the sponsors and the companies to make sure that we have our arms around the performance of the credits, that we’re providing capital for incremental deals when they do them, both add-on facilities, as well as new platforms. But we’re not in a rush at all to get to target leverage for the sake of getting to target leverage. I think it’ll happen very naturally for us, though, just given the quality of our sourcing footprint, the size of our existing portfolio but we’re not in a rush. I think the $64,000 question in terms of when we get there will probably just be what our repayments look like over the course of the year, and of course, no one is a crystal ball. We can make certain assumptions. But we feel really good about our ability to get to target leverage over the next few quarters and I’ll hand it over to Dave.

David Pessah, Chief Financial Officer

Yeah. And just to add, operating at where we are today at 0.81 times levered, we’re still significantly out-earning our regular distribution. In this quarter, in particular, it was at $0.13 over our regular distribution in our core NII. Our NII, we feel pretty confident about as well. Our total investment income is primarily all interest-paying coupons at the top. We’re not reliant on non-recurrent income there. So the ability to maintain our steady-state NII in excess of our dividend, we feel pretty good about. And then, obviously, as Jeff mentioned, as we look to ramp the portfolio, it’s only going to further bolster what our core NII earnings power ultimately is.

Paul Johnson, Analyst

Great. Thanks for that. And then can you just remind us just how much of the remaining lock-ups are set to expire with the private shareholders?

Jeff Levin, President and Chief Executive Officer

Yeah. Good question. There are three equal installments all to transpire in July, October of this year with the final installment in January 2025.

Paul Johnson, Analyst

Thanks. Appreciate it. That’s all for me.

Operator, Operator

Thank you. And we’ll go to our next question from Vilas Abraham with UBS.

Vilas Abraham, Analyst

Hey, everybody. Thanks for the question. Can you update us on your latest thoughts just on the dividend payout and how you’re thinking about later this year with potential special distributions?

Jeff Levin, President and Chief Executive Officer

Thanks for the question. In Q1 and now Q2, with the recent Board declaration, our regular distribution has been $0.50. We're aiming to maintain that regular distribution in the upcoming quarters as well. In the prepared remarks, we mentioned that we will have two special dividends at the end of this year, each worth $0.10. Therefore, we're projecting a total of $2.20 in dividends for the current period. As usual, we'll evaluate our excess spillover at the end of the year, and if it makes sense and we have sufficient spillover for the next year, we will consider the need for a special dividend.

Vilas Abraham, Analyst

Okay. Great. That’s helpful. Thanks. And then, just one of the other themes, I guess, with this earnings season has been CLO issuance and just right side of the balance sheet kind of being diversified in that way at several BDCs. Have you guys thought about that, looked at that, anything there would be helpful?

Jeff Levin, President and Chief Executive Officer

Yeah. We absolutely have a, as you’d expect, frankly, a robust liability management practice here within our private credit business. We have a team dedicated to managing the liability side of our business here, both within this pool of capital, as well as more broadly. So maintaining highly diversified funding sources, both by source of capital as well as type of capital. So, as you know, within this capital structure, we have several different types of borrowing lines. CLO technology and utilizing that is something that we absolutely have considered and will continue to. We haven’t yet, as you noted. We certainly may in the future, if we think it makes sense to layer it into the liability side of our funding sources, but we haven’t yet. But it’s not because we don’t have the institutional knowledge and insight here in terms of the merits of it, obviously. But that’s something that is under consideration, along with, of course, a handful of other considerations on the liability side, as well. Dave, anything you’d add to that?

Vilas Abraham, Analyst

Okay. Thank you.

Jeff Levin, President and Chief Executive Officer

Thank you.

Operator, Operator

Thank you. At this time, I would like to turn the call back to Jeff Levin for closing remarks.

Jeff Levin, President and Chief Executive Officer

Thank you. On behalf of the management team, I greatly appreciate your interest in and support of the Morgan Stanley Direct Lending Fund here. We remain pleased with our progress and believe that we are well-positioned to generate strong risk-adjusted returns for our investors as market trends evolve, and we look forward to providing an update on our second quarter 2024 earnings call in August.

Operator, Operator

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