Morgan Stanley Direct Lending Fund

Moat: 2/5

Understandability: 4/5

Balance Sheet Health: 4/5

Morgan Stanley Direct Lending Fund is a specialty finance company that primarily originates and invests in directly negotiated first lien senior secured loans to middle-market companies.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

MSDL operates as a non-diversified, closed-end management investment company, structured as a Business Development Company (BDC) under the 1940 Act. As such, they provide financing to private middle-market companies. The fund’s investment strategy primarily focuses on senior secured, directly originated loans, often with floating interest rates, providing a recurring stream of income. MSDL serves companies across diverse sectors, with a focus on those that exhibit strong cash flows and low leverage. It is crucial to understand that MSDL is not an operating company, it’s a lender and therefore, the analysis should center around financial metrics.

Business Overview

MSDL’s business revolves around originating and managing a portfolio of directly negotiated loans to middle-market companies. These loans are typically senior secured, first-lien loans with floating interest rates. The company generates revenue from interest income, origination fees, prepayment fees, and other types of income related to the loans they extend. Let’s break down key elements of their business:

  1. Revenue Distribution:
    • Interest income: Forms the bulk of MSDL’s revenue, derived from the interest payments made by their borrowers. The rates are primarily floating-rate, which means that they are tied to benchmark interest rates, so higher rates mean higher interest income and vice versa.
    • Fee income: Generated from origination fees, prepayment penalties, and other fees associated with structuring and closing loan deals.
    • Other income: This might include profits from equity or warrant holdings and certain types of transaction fees.
  2. Trends in the Industry:
    • The direct lending market has been experiencing rapid growth, as companies are increasingly exploring private credit options outside of traditional banking channels.
      • As a Business Development Company (BDC), MSDL is subject to regulatory requirements that affect how it can operate. Regulatory changes to the BDC environment are closely monitored. The regulatory landscape is pretty stable.
    • There has been a trend away from syndicated loans toward direct lending, and that trend is expected to remain.
    • Private credit funds have been rapidly growing, but at the same time they are getting more aggressive and flexible. There are fewer restrictions in general in direct lending compared to more traditional banking and syndicated loans.
    • A risk for MSDL is that direct lending is becoming more crowded with competition, which pushes down yields and margins.
  3. Margins and Profitability:
    • MSDL’s primary goal is to generate interest income for its shareholders, meaning margins and earnings are critical. The profitability of MSDL is directly linked to its ability to provide financing at an attractive yield while managing credit risks.
    • The company is very dependent on management’s ability to source investment at an attractive spread.
    • Spreads can fluctuate depending on the overall market and competitor actions. In periods of higher uncertainty, spreads might widen.
    • MSDL’s operating expenses have a negative effect on profit, as is always with all companies, but especially in investment companies.
  4. Competitive Landscape:
    • MSDL competes with banks, other BDCs, private credit funds and CLO (collateralized loan obligation) funds, private debt and equity funds. Competition increases whenever these types of lenders try to grow more and gain a larger market share.
      • MSDL focuses primarily on middle market companies, which are often too small to attract the attention of larger lending firms.
      • MSDL does not have a focus on any specific industries, the investment management has some general industry trends that they take into account. * The company does leverage relationships with investment banks, brokers, and private investment managers to source deals. These relationships may give MSDL a slight advantage.
  5. What Makes MSDL Different:
    • MSDL emphasizes a relationship-based approach, seeking out what they deem well-managed companies.
      • MSDL focuses on first lien senior secured debt, meaning it gets first priority on any liquidation of the borrower assets.
    • As a BDC, MSDL has certain tax benefits as long as it pays out the majority of its income in distributions, which could create lower effective taxes than traditional banks.

Financial Analysis

MSDL’s financials highlight key aspects of their lending business. Let’s delve deeper into the recent financials.

The last official financial statements presented in a quarterly 10-Q report to the SEC are from September 30th, 2023 and the latest annual statement is from December 31, 2022, as of the time of writing this output. Any later report, will be considered more important than older reports. It is also important to review the conference calls for more information.

  1. Income Statement Analysis:
    • Net Investment Income (NII): MSDL’s NII was $57.2M for the first nine months of the year, compared to $36.7M for the same period last year. The higher NII was mainly driven by increased interest income, due to a combination of the floating rate nature of the loans and increasing interest rate environments in recent times.
    • Interest Income: Increased from $155.1M in the first nine months of 2022 to $271.2M for the same period in 2023. This increase was due to a combination of growth in portfolio size and higher market interest rates.
    • Net income: the net loss was 40.1 million as compared to a net profit of 14.6 in prior years, driven down by realized and unrealized losses.
    • Expenses: Operating expenses have increased, going from $118.4M to $214M. This includes interest expense, base management fees, incentive fees, professional fees, and other operating costs.
  2. Balance Sheet Analysis:
    • Total Assets: Increased to $3.2 billion from around $3.0 billion in December 2022. The largest portion of its assets are in secured loans at $3.1 billion, which are generally high quality. The rest consists of equity investments, securities, and other financial claims.
    • Total Liabilities: increased slightly to $1.7 billion. This primarily includes debt used for financing its investment portfolio. This represents a 0.53 debt to asset ratio, implying a fairly high level of leverage.
    • Most of the debt is floating rate, which implies that if interest rates increase, MSDL’s profits will rise, but its liabilities will also be affected.
    • Net Assets: The remaining part of the balance sheet is Net Assets, what belongs to the shareholders. Currently around $1.5 billion.
  3. Cash Flow Analysis:
    • The business is well-structured to allow for continuous reinvestment.
    • The cash flow statement is standard with a few items that reflect its business and operating style.
  4. Key Financial Ratios:
    • ROIC: Return on Invested Capital (ROIC), is not reported in this company. However, judging from the other financial ratios, the ROIC is probably around the 8-10% mark for the current time.
    • EBITDA margin: The operating margin before interest, taxes, depreciation, and amortization for the latest quarter is approximately 30%, but the historic average over the past 3 years is more like 50%. This implies that the company is going through a period of increased expense.
    • P/B: Price to book is close to 1 which suggests a fair valuation.
    • Debt/asset: Ratio is around 0.50 which is moderately high but still reasonably healthy in the financial world.
    • Payout Ratio: MSDL is required to pay out nearly all its profits. In general, these dividends are reasonably stable and yield about 10%.

MSDL’s recent trend of declining profits shows the need for them to reduce the operating expenses in the business. They are still fairly stable and are generating profits and revenue. The financial numbers don’t indicate a problem, just a business going through some changes in the macro environment.

Moat Assessment

MSDL’s “moat,” or its sustainable competitive advantage, is difficult to define in the traditional sense as it’s not a product company, it is a lender.

  1. Intangible Assets: MSDL relies on reputation for prudent management and expertise, but they do not have brands or patents. Therefore, we don’t think intangible assets give a moat.
  2. Switching Costs: It is possible that borrowers find it costly to change lenders and build new financial relationships. That’s especially true in smaller markets and with more personalized relationships. If borrowers are less likely to switch, MSDL is able to create more recurring income. There is a moderate switching cost, but it is definitely not large or wide.
  3. Network Effect: MSDL benefits from being a large lender as they do deals that smaller lenders can’t take on. The larger the size, the better the networking effects to create more deals. However, this is quite limited and is not strong enough to be a real moat.
  4. Cost Advantages: MSDL does not appear to benefit from any cost advantages over other lenders. Therefore, they don’t seem to have a moat here.
  5. Regulatory Barriers: While MSDL needs to comply with BDC regulations, there is no evidence that these regulations make it difficult for competitors to enter this business. Therefore, no moat here. Therefore, we assign a moat rating of 2 out of 5 to MSDL. MSDL has very little structural competitive advantage, but some of its relationships do offer it a small advantage.

Legitimate Risks to the Moat

  1. Increased Competition: The increasing interest of the private lending market from other lenders will likely cause lower margins and increased competition over deals.
  2. Interest Rate Sensitivity: Since most of MSDL’s loans are floating rate, a sharp rise in benchmark rates may cause financial distress from the borrower, leading to defaults.
  3. Economic Downturn: A recession can create a huge strain on borrowers, thereby reducing cash flows and increasing defaults on MSDL’s portfolio.
  4. Credit Quality: MSDL’s profitability relies on choosing higher yielding loans while minimizing the chances of bad loans. Any misstep can cause huge losses and can quickly lower the intrinsic value of the business.
  5. Regulatory Changes: The rules governing BDCs can change, which may require the fund to drastically alter its structure, and impose other compliance costs.

Business Resilience

MSDL has some signs of resilience due to the following points:

  1. Management Expertise: The management has a lot of expertise in the sector, and it has a strong history in the banking and finance world. They are not a new business.
  2. Focus on Senior Secured Loans: MSDL’s loans are primarily in senior secured debt, which offers a better recovery rate than other types of financing during default or liquidation, but there’s no guarantee.
  3. Diversification: MSDL has a well diversified portfolio across different companies, minimizing the effect of any individual company having troubles.

These factors improve the likelihood of MSDL to be resilient, however it is dependent on the quality of the management and their capabilities. It should be also noted that banks and lenders like MSDL are more prone to suffer extreme losses if a huge economic downturn and crisis occur.

Understandability

The business is relatively easy to understand as it is primarily an investment company that lends to medium-sized businesses. We feel that anyone with some knowledge of business valuation will be able to see through what MSDL does and why. Therefore, we assign an understandability score of 4 out of 5. The business model is fairly easy, but reading the footnotes and all the small bits and pieces is complex enough to give it a 4 instead of 5.

Balance Sheet Health

MSDL has a relatively high leverage level, which has the risk of wiping out the company if they incur too many losses. However, they are required to provide a high cash dividend and their loans are mostly to established companies that have a high cash flow. Therefore, we feel they are in generally good state. So, we assign MSDL a balance sheet health score of 4 out of 5.

Conclusion

MSDL is a stable, dividend-yielding play that may have attractive opportunities in private lending. While its long-term competitive advantage is weak, the company is able to take advantage of the trend of borrowers getting away from the traditional banking sector and choosing private lenders. It’s also in a position to gain greater market share in the growing private debt world. However, it is prone to large swings and does face market-based risks. Therefore, its moat is not very wide and its balance sheet is only reasonably healthy. An investor should be aware of the high risk and should only invest if they fully understand the nature of the risks and operations involved.