(MSDL) on Q1 2024 Results - Earnings Call Transcript
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: 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 can be accessed on the Investor Relations 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, 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: 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 fact that the broadly syndicated loan market is functioning, 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: 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 [ph], 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 on Slide 14 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: Thank you. [Operator Instructions] And we can go with our first question from Robert Dodd with Raymond James.
Robert Dodd: 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 power 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: 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. The 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: Got it. Got it. Appreciate it. On one of the themes that’s been true as well in the last year or so, and including in this quarter, a lot of follow-on activity. I mean, the advantage of being an incumbent lender, right? Is that expected to stay elevated for the, I mean, is some of this activity just your portfolio companies taking the opportunity to acquire even more or do you expect more -- do you expect the mix over the next 12 months to shift back to somewhat towards more new platform kind of deals?
Jeff Levin: 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: Got it. Appreciate that color. One more, if I can. On the credit quality side, obviously, a lot of [Technical Difficulty] 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: 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: Got it. Thank you.
Jeff Levin: Thank you.
Operator: Our next question comes from Melissa Whittle with JPMorgan.
Melissa Whittle: 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: Yeah. That’s a great question. Yeah. It’s certainly no secret that the syndicated loan market has become extraordinarily strong and is a, I’d say, a significant competitive threat to the largest end of the private credit market. So the businesses that have access to the syndicated loan market now, of course, are actively contemplating what the right product is. I think private credit, from a macro standpoint, will continue to grow over time, irrespective of the health of the public credit market, for a lot of the reasons why businesses of all sizes, including large, do use private credit. But repricing volume unquestionably has picked up in Q1. I think it’ll continue to over the course of the year, assuming the public markets stay as healthy as they are today and maybe they tighten further. Who knows? So that’s something that we’re watching closely. I think one way that we’re somewhat well positioned relative to some of our competitors is that, our portfolio does span up and down the size spectrum. So there are plenty of businesses in our portfolio that are not candidates for the public markets. Those are the deals that would be most prone to repricing. But we are seeing repricing up and down the size spectrum. But it’s generally geared towards the highest end of the market. And from a -- in terms of where that -- how that plays out over the course of the year, I do think it’ll continue. I think we’re in constant dialogue with the borrowers and private equity owners within our portfolio in that regard. I also think, back in 2023, when the market was deploying capital at SOFR+ 625, 650, 675, I think the market generally had a feeling that that was not necessarily sustainable if rates were going to stay higher for longer. That seems to be consensus now, obviously. So even as spreads have tightened a bit here, the overall, the all-in return profile and yield that we’re able to generate, even with the tightening, we still think is very attractive given the risk that we’re taking.
Melissa Whittle: 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: Yeah. Yeah. Great question. So, the capital that we invested over the first -- during the first quarter was generally in line with the broader portfolio characteristics. So, weighted average EBITDA about $100 million, median EBITDA in the $60-ish million range, which is consistent with the broader business we have here. Median EBITDA has generally been in the $60 million to $70 million range and then it’s larger than that today because these businesses have generally grown. In terms of where we see value, it’s up and down the spectrum, frankly. One of the benefits of our origination footprint, we cover about 400 buyout funds across our team, close coordination with the investment bank here as well and so the sponsors that we cover are truly up and down the size spectrum. If I look at our first quarter of deployment, it’s really sponsors of all sizes. Thoma Bravo on the high end, Charles Bank being a core middle market sponsor, Summit Partners, Harvest Partners, Vista. It’s really up and down the size spectrum. And that’s one of the things that we like about our platform, which is we’re not boxed into one part of the market. We don’t have to live by deploying capital at the highest end of the market. We don’t -- we certainly don’t live in the lower middle market as well. And so we do -- we’ll toggle up and down the size spectrum based on where we see value and risk return, and every deal is really structured based on the merits and considerations within that specific opportunity. Generally speaking, though, the loan-to-value has been 40% to 45%. As we mentioned earlier, we led or co-led about 80% of the deals that we did in the quarter. We led or co-led all of the LBOs that we did in the quarter. So, again, our leadership position in the market continues to improve and increase, frankly, given the increased scale of our broader private credit business. In terms of when we get to target leverage, over the next few quarters, we would expect to accomplish that. The -- is it in Q2, Q3 or Q4? I frankly don’t know. I’m not worried at all, though, Melissa, about our ability to deploy capital really well. We certainly have an extraordinarily strong origination engine here. But we’ve tried to balance that, of course, with investing in what we see as the highest quality opportunities. As I always tell the team, it’s easy to make a loan. We could get to target leverage really quickly if we widened out our risk aperture or took larger positions. But we really are going to continue to stick to our defensive strategy, be highly selective, have measured hold sizes. We’re big believers in diversification as a critical risk management tool. So, I have a lot of conviction that we’ll certainly get to our target leverage multiple TBD exactly when. But we feel really good about the quality of the book right now, our ability to deploy the capital that we have and the footprint that we have within the private equity ecosystem.
Melissa Whittle: That’s really helpful. Appreciate the information. Thank you.
Operator: [Operator Instructions] Our next question comes from Paul Johnson with KBW.
Paul Johnson: 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 [ph] 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: 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 and 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: 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: 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: Yeah. Good question. There’s three equal installments all to transpire in July, October of this year with the final installment in January 2025.
Paul Johnson: Thanks. Appreciate it. That’s all for me.
Operator: Thank you. [Operator Instructions] And we’ll go to our next question from Vilas Abraham with UBS.
Vilas Abraham: 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: Yeah. Great question. So Q1 and now Q2 with the Board declaration that we just announced, our regular distribution has been $0.50. I think we’re ultimately trying to stick to maintaining that regular distribution in the coming quarters as well. In the prepared remarks, we also highlighted that we do have two special dividends at the tail end of this year of two $0.10 dividends. So ultimately that would be now looking at $2.20 in ultimate dividends that we’re projecting for the current period. Like we -- what we normally do, we’ll assess at the end of the year what our excess spillover is at that point in time and to the extent that it makes sense that we have ample spillover in the following year, we’ll evaluate the need for a special.
Vilas Abraham: 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: Yeah. We -- absolutely, we 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: Okay. Thank you.
Jeff Levin: Thank you.
Operator: Thank you. At this time, I would 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 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: This concludes today’s call. Thank you for your participation. You may now disconnect.
