MSDL: Attractive Entry Point On Lock-Up Expiry In This 11.6% Yielding BDC

In this article, we take a look at the Q2 results for the BDC Morgan Stanley Direct Lending Fund (NYSE:MSDL). MSDL falls under the $18bn Morgan Stanley private credit platform, which itself sits under the $1.5trn Morgan Stanley Investment Management. The company completed its initial public offering earlier this year, after operating as a private BDC for several years. MSDL trades at an 11.6% yield – above the median in our coverage, and a slight discount to book. MSDL delivered a 3.3% total NAV return for the quarter, well above the 2.3% median in our coverage.

Much like the rest of the BDC space, MSDL allocates primarily to less-cyclical sectors such as Software, Insurance, and Commercial Services. It is somewhat underweight Healthcare, a sector which is often one of the top two sector weights for BDCs.

The portfolio has 192 investments – somewhat higher than the sector average level – with the largest position at 2.5% of the portfolio, making it relatively well diversified. The median EBITDA was $82m, putting it right in the middle-market sweet spot, below upper middle-market focused BDCs such as ARCC and BXSL and above those focused on the lower middle-market such as CSWC and FDUS.

As is typically the case with BDC IPOs, there are several lock-up expiry dates to keep an eye on, which are October 19, 2024, and January 22, 2025. MSDL has put in place a $100m share repurchase program whereby the company can repurchase shares below the NAV. This, alongside the post-lock-up special dividends, is intended to support the share price as pre-IPO shareholders exit.

Quarter Update

Net investment income rose slightly in Q2 vs. the previous quarter.

The company declared the same $0.50 base dividend. There are also two previously declared special dividends of $0.10 to be paid in October and January to support the stock during lock-up expiries. Base dividend coverage is 126%. Spillover income was $0.71.

The NAV increased by 0.8%, primarily due to retained income.

The NAV has recovered after a brief dip in 2022.

Income Dynamics

Net investments rose 6%. This pushed leverage higher to 0.9x though it remains well below the sector average. Management said they expect to raise leverage further to their target level and this would be a tailwind to income generation. The company’s net investment income of 12.15% is slightly below the median in our coverage.

During the quarter, the company issued a 2029 6.15% bond which it then swapped to a floating rate of SOFR + 2.37% (interestingly, the fixed rate of the swap was 6.41% rather than 6.15%). The adjusted rate of SOFR + 2.1% is quite a bit above the larger BDCs like BXSL and ARCC that have been swapping issuance at SOFR + 1.4-1.6% this year. The swap will raise the interest expense on the bond from 6.15% to around 7.2%; however, it will fall over time as the Fed cuts rates.

The portfolio net investment income is expected to fall around 11% for each 1% drop in SOFR. The market currently expects around a 2% drop in the Fed policy rate.

The company is waiving 0.25% of its 1% base management fee and 2.5% of its incentive fee until early next year. Once the waivers roll-off, NII should fall by around 7% from the current level, equating to base dividend coverage of around 117%.

Portfolio yield has fallen slightly while interest expense has been stable. The company’s portfolio yield and yield spread are below the average in our coverage, likely due to the first-lien overweight. This is partly offset from a net investment income perspective with a low management/incentive fee structure.

Portfolio Quality

Non–accruals on cost have fallen to 0.3% – the lowest level in our coverage.

PIK income was well below the sector average at 2.7%. Net realized losses have been low.

The company has been focused on allocating capital to almost entirely first-lien loans as shown below. Its overall first-lien allocation is 95% – well above the median of 85% in our coverage.

Performance and Valuation

MSDL has outperformed the average BDC in our coverage over the last several years. Because fees have risen since the IPO and the waivers will be coming off next year, the company is unlikely to maintain the same level of outperformance going forward, however, some level of outperformance should continue.

The stock’s valuation rose quickly after the IPO but has since been knocked back after the first lock-up expiry in July. We took advantage of this dislocation as well as the early August market sell-off to add a position in the stock. Since then, MSDL has rallied quite a bit, now offering a less attractive entry point. Investors may be better served by waiting for a potentially better October entry point on the second lock-up expiry.

The stock is still trading at a discount to the average valuation (flat to the median valuation).

Overall, MSDL looks to be a BDC with a higher-quality portfolio. Its focus on a lower-yielding, first-lien portfolio has generated stable returns with a low level of non-accruals and realized losses. The recent lock-up expiry offered an attractive entry point, though this closed fairly quickly. October could deliver another bout of volatility for the stock, allowing investors to add to the position.