Earnings Call Transcript - MSDL Q3 2024

Operator, 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, Head of Investor Relations and Chief Administrative Officer

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. 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 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. 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, Chief Financial Officer

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, amounting 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 2.85% to 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, Operator

Thank you. And the first question today comes from Sean-Paul Adams with Raymond James.

Sean-Paul Adams, Analyst

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, President and Chief Executive Officer

Yeah, this is Jeff. Thanks for the question. It's quite difficult to predict. Deal flow can vary significantly from year to year. Currently, there are positive indicators for deal flow overall, especially with greater clarity in the rate environment as rates decrease. With the election behind us, and considering the time constraints faced by private equity firms—losing investment time each quarter—I believe they will aim to invest their capital rather than return it to their limited partners. However, for a meaningful increase in deal flow, the differences between buyer and seller expectations need to lessen. I anticipate that 2025 will be a stronger year, although predictions are challenging. While pipelines are better now compared to early 2024, there's still a substantial amount of capital waiting to be deployed, which bodes well for 2025 and 2026. Additionally, even during the first three quarters of this year, with LBO volumes being relatively low, we managed to effectively deploy capital without taking on excessive risk. This reflects well on our top-notch direct origination team. We have around 75 professionals focused on private credit in the U.S., with a significant portion dedicated to sourcing deals. We uniquely benefit from having no other direct lending operations within Morgan Stanley in the U.S., allowing us to optimize deal flow and make selective investments. Given our institution's size, we enjoy greater origination capabilities compared to others in the private credit market. Overall, we're optimistic about our capital deployment throughout the first three quarters of the year, despite lower LBO volumes, and see promising opportunities ahead. Moreover, the size of our portfolio, which includes nearly 300 entities, is advantageous as these businesses may shift ownership or need additional financing for acquisitions as volume increases. I hope that provides clarity.

Sean-Paul Adams, Analyst

Thank you for all that clarity and I appreciate you going into such deep detail. I appreciate it. Thank you.

Operator, Operator

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

Melissa Wedel, Analyst

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, President and Chief Executive Officer

Sure. It’s Jeff. I’ll begin and then hand it over to Dave. Thanks for your question, Melissa. Generally, I’d say the current market backdrop shows that repricing activity has definitely slowed, which is positive compared to the previous quarter. There was a time in 2024 when it seemed like spreads were tightening, with more deals closing at the 4.75 level and some at 4.50. However, that tightening appears to have decreased, and we are currently in a market around SOFR plus 500. The spread outlook for the rest of this year into next year will depend on expected changes with SOFR. But regarding pressure on new deal spreads and repricings, it seems to have eased significantly. Dave, could you provide more insight into the yield compression in the portfolio?

David Pessah, Chief Financial Officer

Yes. So our yield quarter-over-quarter went down 60 basis points. The 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, Analyst

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, Chief Financial Officer

Thank you for the question. Our base dividends are well covered, with a coverage of 132% for the quarter. There was $0.77 of spillover, and we also have a $0.10 special dividend from the IPO in the fourth quarter, which leaves us with a spillover of about $0.67. We aim to maintain approximately one quarter's worth of spillover, and our current levels provide us with a cushion to navigate the upcoming rate environment. The situation will depend on the speed of rate decreases, and we will evaluate the need for supplemental dividends as we approach 2025. Overall, this allows us to maintain stability in our core dividend of $0.50 moving forward.

Melissa Wedel, Analyst

Thank you.

Operator, Operator

Our next question will come from Paul Johnson with KBW.

Paul Johnson, Analyst

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, President and Chief Executive Officer

Yeah. Great question. I’d say it’s been quite stable. We haven’t seen all that much movement 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 a 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, Analyst

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

Operator, Operator

And our next question comes from Kenneth Lee with RBC Capital Markets.

Kenneth Lee, Analyst

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, President and Chief Executive Officer

Thank you for the question. The pipelines appear stronger today than they did a few months ago. It's always challenging to forecast how much volume will close in any given quarter, and we don't focus on the business in that way. We aim to originate as effectively as we can, conduct thorough diligence, and invest in what we believe are the best opportunities in the market. We're pleased with how we reached our leverage target a few quarters post-IPO, as we anticipated. This was achieved in an environment where LBO volumes were down, and we remain selective. We're optimistic about the LBO market potentially strengthening, but even if it doesn't, I am confident in our ability to deploy capital effectively in 2024, which reflects the robustness of our sourcing platform. As for Q4 compared to Q3 or Q2, it's too early to predict volumes, but we are content with the overall health of our portfolio and the composition of assets in the sectors we are invested in, which was intentional. We closely monitor these portfolio companies. Generally, as interest rates decrease, we anticipate more cash flow generation at the borrower level, which is beneficial. We leverage information from our portfolio and broader insights across the Morgan Stanley ecosystem when making investment decisions. We consistently avoid sectors we consider more cyclical, such as retail, restaurants, and energy, and I don't see that changing. We also tend to steer clear of healthcare businesses with significant reimbursable risks. Our strategy for the future remains consistent with the past, focusing primarily on software and insurance brokerage, both of which are performing well. However, we have noticed increased softness in the logistics sector, so we are being more cautious there. Overall, we will continue to invest diversely at both the borrower level and by industry sector while being selective with both borrowers and sponsors we're financing. I hope that answers your question, Ken.

Kenneth Lee, Analyst

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, President and Chief Executive Officer

That's a great question. We cover 400 sponsors within our business. We have offices in New York, Chicago, and Los Angeles. The senior members of our investment team have more than 20 years of experience in this business, which adds a wealth of knowledge to our investment committee. Many of the deals we encounter, whether we pursue them or not, are ones we've reviewed multiple times throughout our careers. In our portfolio, about half of the deals exceed $100 million in EBITDA, while the other half fall below that threshold. Our team's coverage of sponsors, combined with the firm's sell-side capabilities, gives us what we believe is best in class reach. This enables us to pursue higher market opportunities when they arise, as well as engage in the core middle market where we see attractive risk-reward scenarios. For instance, in 2023, while the syndicated loan market was shut, various businesses with EBITDA ranging from $200 million to $500 million were approaching the private credit market, presenting excellent risk-adjusted returns, strong management teams, and considerable value options. We invested in some of these opportunities. In 2024, due to the state of the syndicated loan market, there are fewer large unitranche deals available. Consequently, we are focusing on the core part of the middle market, which I define as businesses with EBITDA ranging from $30 million to $125 million. We have faced no challenges in deploying capital in this segment. The risk-return profile does fluctuate based on market conditions we encounter. Generally, we tend not to lend to companies with EBITDA under $25 million, as they tend to be more vulnerable. The management teams in these companies may not be as sophisticated, and there tends to be heightened customer and supplier concentration. The spread premium in this segment is also less attractive since many lenders can underwrite and manage lower middle market deals, making the supply-demand dynamics less appealing. We will continue to navigate between different sizes based on where we identify value. This assessment is influenced by the strength of the underlying business, the proposed capital structure, and the robustness of the covenant package, including both financial and negative covenants. It’s a comprehensive evaluation. What I appreciate about our strategy is the ability and flexibility to adjust our focus along the size spectrum where we see value.

Kenneth Lee, Analyst

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

Jeff Levin, President and Chief Executive Officer

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, Operator

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