Morgan Stanley Direct Lending Fund (MSDL) Earnings Call Transcript & Summary

Welcome to Morgan Stanley Direct Lending Fund Second Quarter 2026 Earnings Call. [Operator Instructions] As a reminder, this conference call is being recorded. At this time, I'd like to turn the call over to Sanna Johnson, Head of Investor Relations. Please go ahead.

Good morning, and welcome to Morgan Stanley Direct Lending Fund Second Quarter 2026 Earnings Call. I am joined this morning by Michael Occi, Chief Executive Officer; Jeff Day, Co-President; David Pessah, Chief Financial Officer; and Rebecca Shaoul, Head of Portfolio Management. Morgan Stanley Direct Lending Fund's Second Quarter 2026 financial results were released yesterday after market close and can be accessed on the Investor Relations section of our website at www.msdl.com. We have arranged for a replay of today's events 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 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 Michael Occi.

Good morning, everyone, and thank you for joining us today. I'll begin with our second quarter performance and outlook before turning the call over to Jeff to discuss the market environment and deployment activity. David will then review our financial results in greater detail, after which we will open the call up for Q&A. Beginning with operating results. We generated net investment income of $0.45 per share compared with $0.47 per share in the prior quarter. Second quarter earnings reflected a growing contribution from the Capstone JV, offset by the income drag associated with new nonaccruals added during the quarter and higher other financing costs. For the third quarter, the Board declared a dividend of $0.45 per share, unchanged from the prior quarter. Second quarter net investment income covered the dividend, and we continue to believe the reset dividend level is aligned with MSDL's normalized earnings power. Transitioning to credit. MSDL's overall portfolio health remains solid. NAV compression in the quarter was attributable in large part to a handful of underperforming investments, which had previously exhibited weakness. The increase in nonaccruals reflected the weighting of net borrower addition to nonaccrual status. Importantly, the proportion of the portfolio in the risk rated 2 or better categories remained stable quarter-over-quarter with approximately 95% of the portfolio generally performing in line with the original underwriting case. Consistent with the first quarter, we took a disciplined approach to capital allocation amid a more dynamic market landscape, seeking to thoughtfully manage leverage and maximize risk-adjusted returns. We remained active in utilizing our share repurchase program, which added $0.05 to NAV per share during the quarter and brought total program-related accretion to $0.10 for the first half of 2026. In parallel, we continue to scale the JV, which we expect to further ramp over the coming year. While conventional investment activity remained measured as we balance these levers, origination momentum remains solid with 3 new platform investments added during the quarter. On the liability side, we successfully executed 2 proactive financing initiatives, the amendment and extension of our corporate revolver in April and a subsequent unsecured notes offering in June designed to prefund a portion of our February 2027 maturity. Together, these transactions underscore a proactive management of the right-hand side of the balance sheet and our continued access to diversified financing sources, supported by the strength of our business and the depth of MSPC's relationships with bank partners and the fixed income community. Turning now to our outlook. We would characterize the first half of 2026 as a period of transition for direct lending. Public market valuations are pricing in a more negative outlook than our current portfolio fundamentals support. At the same time, there have been isolated instances of credit softness, and we recognize that several legitimate pressures persist in the market. Borrowers continue to face elevated interest rates, geopolitical uncertainty and the evolving impact of AI. But the underlying fundamentals of the middle market economy remain resilient. Credit performance will vary across the industry as these headwinds affect companies and sectors differently. However, we believe several of these pressures are beginning to ease and the MSDL portfolio is well positioned to navigate them. Jeff will discuss these dynamics in greater detail shortly. We also remain constructive on the medium- to long-term outlook for new deal activity, although industry lending volume during the first half of the year was more uneven than anticipated. Sponsors remained selective in the second quarter amid geopolitical developments in the Middle East. Encouragingly, we have seen a rebound in private equity exit activity, supported by efficient financing markets and strong demand from strategics. We expect new deployment could accelerate as sponsors gain greater conviction in the geopolitical and macro backdrop. Even amid subdued market-wide activity relative to expectations at the start of the year, opportunity levels remained respectable in the second quarter. Our deep integration within the Morgan Stanley ecosystem continued to provide what we consider to be a meaningful sourcing advantage. We reviewed a higher number of deals year-over-year and closed on less than 5% of the opportunities we originated in the last 12 months, reflecting both our broad funnel and our high-quality bar. While headlines around direct lending fund flows have weighed on retail investor sentiment, we have observed constructive investor engagement across channels through the lens of our platform's diversified capital base. Notably, industry-wide institutional demand for the asset class remains strong globally with many investors continuing to seek increased allocations. Retail outflows also showed signs of deceleration in the second quarter, reinforcing our confidence that direct lending will remain a durable allocation for individual investors. And there will be a need for this capital as private equity dry powder is deployed and sponsor-backed M&A volume builds. Morgan Stanley Investment Management recently surpassed an important $2 trillion AUM milestone. As a visible component of MSIM's growing credit platform, we remain confident in our ability to continue optimizing the performance of MSDL, leveraging the strength of our team, track record and broader support of the Morgan Stanley platform. When we constructed MSDL, we endeavored to provide a differentiated BDC offering, aligned with shareholders through our thoughtful fee structure, competitive expense profile and defensive investment strategy. We remain intently focused on these priorities, positioning MSDL to capitalize on this dynamic backdrop and to continue delivering value to shareholders. With that, I'll turn the call over to Jeff Day.

Thank you, Michael, and good morning. As we reflect on the market environment, we see a backdrop for private credit in which selectivity and underwriting discipline remain critical. We saw improved supply-demand technicals support a positive shift in deal terms during the second quarter, which was a continuation of the dynamics experienced in the first quarter. We believe this trend is driven primarily by slower capital formation in the market. Pricing for new loans generally stabilized quarter-over-quarter in the SOFR plus 500 basis point range with our weighted average spread on closed deals in the second quarter unchanged relative to the first quarter. While spreads remain wide to the mid- to high 400s trough reached in mid-2025, competition remains high for non-software assets, and we have witnessed some modest tightening in this part of the market third quarter to date. Beyond pricing, documentation and overall lender protections remain favorable relative to what we observed in mid-2025. Financial covenant packages, EBITDA definitions, requests for PIK toggles at close and other structural protections continue to compare favorably with what we were seeing several quarters ago, allowing disciplined lenders with strong sponsor relationships to continue generating improved risk-adjusted returns. In general, we continue to find better compensation for risk in the upper middle market where larger financings typically require more lender participation than in prior years or than in the lower middle market. From a use of proceeds perspective, we have also seen a healthy shift in deal composition with LBOs and add-on acquisition activity accounting for more than 75% of our new platform activity in the first half of the year. As it relates to second quarter originations, we closed on 11 first lien senior secured transactions totaling $85 million of new commitments. These included 3 new platforms, 4 refinancings of existing borrowers and 4 incremental commitments to existing portfolio companies, highlighting both the strength of our sponsor relationships and the continued opportunity within our incumbent portfolio. One transaction to highlight from the quarter was Bridgepointe. During the quarter, Bridgepointe approached the market with a leverage buyout financing opportunity. Our platform's familiarity with the business and ability to speak for a sizable commitment allowed MSPC to take on leadership roles as both a lender and administrative agent. The transaction improved our lender position and the credit through the addition of significant additional cash equity from the sponsor beneath us in the capital structure while further reducing risk through improved documentation protections. In addition to balance sheet deployment, we deployed an additional $10 million of equity into the Capstone JV. David will elaborate on the current profile of the JV, and I would invite you to review the new slide we added to our investor presentation this quarter with additional details on the JV. While the investment strategy within the JV is identical to that of on-balance sheet deployment, accounting for the JV portfolio modestly diversifies our top borrowers' weights as of June 30, 2026. The JV provides an additional source of portfolio growth, which we expect to support NII generation as it continues to scale. Turning to credit. Overall portfolio performance remained broadly stable during the quarter. Revenue growth, EBITDA growth and interest coverage ratios remained healthy and improved from the prior quarter. While payment in kind income has increased slightly, the number of borrowers utilizing PIK remained relatively unchanged from the prior quarter. We continue to closely monitor PIK utilization and have prioritized lending to borrowers who have the cash flows to support the capital structures that we are providing to them. Our mid-single-digit level of PIK remains low relative to publicly traded BDC peers, which we believe is a strength of our portfolio. As part of these ongoing portfolio management efforts, we also placed US Infra Services Buyer, Spectrio and VPG Holdings on nonaccrual status. These were not new issues that emerged during the quarter. Each company had been experiencing company-specific operational challenges over an extended period, and the move to nonaccrual reflects the continued progression of those situations. We do not view their performance as indicative of broader portfolio stress or specific sector trends. These 3 credits contributed to the NAV mark-to-market movement in the quarter and increased nonaccruals to 2.9% of the portfolio at cost as of June 30. Restructuring efforts remain active, and we continue to work closely with all relevant parties to preserve principal and achieve timely resolutions for our nonaccrual investments in the coming quarters. During the second quarter, we continued to actively manage challenged situations and successfully completed restructurings for both BCA buyer and Abcam. These outcomes reflect the deep experience of our senior team and our hands-on approach to portfolio management as well as our ability to work constructively with sponsors and management teams to maximize value through periods of operational stress. While several variables may impact how MSDL's credit will evolve over the coming quarters, we believe that the portfolio remains well positioned to navigate different economic scenarios and importantly, the risk ratings distribution is indicative of stability. As Michael alluded to, the proportion of the book risk rated 3 and 4 declined modestly during the quarter on a fair value basis. We have a proven track record of preserving capital for shareholders. And while NAV may fluctuate from quarter-to-quarter, we believe our active management of the affected credits positions us to preserve value, maximize recoveries and support NAV stability over time. MSDL's NAV per share remains within 2.5% of its starting NAV per share at inception in 2019. Turning now to software. We have seen the conversation around artificial intelligence become more balanced over the last few months. We believe AI will remain an important area of focus for every industry and its company-specific impact is going to vary meaningfully by business model, end market and product offering. As such, we believe AI is unlikely to drive near-term sector-wide disruption. Our software investments remain concentrated in mission-critical system of record platforms with high switching costs, recurring revenue characteristics and strong customer retention. Through our ongoing portfolio monitoring and team's proprietary AI scorecard, we continue to identify a low single-digit percentage of our portfolio we consider in the high-risk category. We believe our portfolio companies are well equipped to leverage AI to enhance product functionality, improve operating efficiency and strengthen their competitive positioning over time. Beyond AI, we continue to closely monitor the evolving macroeconomic and geopolitical environment, including renewed volatility in energy markets as tensions in the Middle East have intensified. In line with other macro-related reviews we conducted over the last several quarters, this quarter, we conducted an assessment of potential exposure impacts across the portfolio. Based on that analysis, we remain confident that our portfolio is well positioned, where fuel is a more meaningful input cost, we currently expect the majority of those borrowers will be able to pass higher costs through to customers over time. Given our concentration in service-oriented businesses, we believe direct exposure remains limited. Overall, while we continue to monitor a small number of company-specific situations and an evolving macro backdrop, we believe the portfolio remains well positioned. I will now turn the call over to David Pessah.

Thank you. Turning to our balance sheet. Our portfolio totaled $3.6 billion at fair value as of quarter end. With our continued focus at the top of the capital structure, approximately 93% of the investments were classified as first lien debt, 3% in our JV and the remainder in second lien equity and other investments as of June 30. Inclusive of new investment commitments, total investment fundings amounted to about $146 million during the quarter, offset by $240 million in repayments. The portfolio remains well diversified with 229 portfolio companies across 36 industries and an average borrower exposure of approximately $15.5 million. In addition to some of our credit metrics that Jeff provided, the weighted average loan-to-value across our portfolio was approximately 39% and median EBITDA remained relatively unchanged at $90 million. To provide some additional detail about our JV, the vehicle has total equity commitments of up to $250 million, of which $200 million is committed by MSDL. To date, approximately 52% of the total equity commitments have been called, supporting approximately $426 million of investment commitments across 58 portfolio companies in 25 industries. The weighted average yield on debt and income-producing investments is 8.8% at cost. On a levered basis, the dividend yield on MSDL's investments equated to approximately 13%. Moving to our operating results for the quarter. Net investment income for the quarter was $38.2 million or $0.45 per share. Total investment income was relatively unchanged at $89 million. Earnings from the JV increased meaningfully during the quarter. However, that benefit was offset by the impact of positions placed on nonaccrual, which in turn decreased the weighted average yield on our portfolio. Total expenses increased to $50.6 million from $48.6 million in the previous quarter, attributable to higher other debt expenses as well as an increase in incentive fees resulting from a smaller benefit from our incentive fee cap impact this quarter. The net change in unrealized depreciation and realized losses for the second quarter was $30.2 million. Unrealized losses were driven by underperformance in a handful of portfolio companies, which includes the aforementioned positions that were placed on nonaccrual. Net realized losses during the period were related to the 2 restructurings that were completed. As of June 30, our total assets were $3.7 billion and total net assets were $1.65 billion. Our ending NAV per share for the second quarter was $19.50 compared to $19.81 in the prior period. The gross debt-to-equity ratio closed the quarter at 1.21x, modestly below the 1.22x multiple from the previous quarter and comfortably in the target range of where we like to operate. Unsecured debt was 56% of total funded debt at the quarter end. During the quarter, we successfully amended and extended MSDL's senior secured corporate revolver, extending its maturity while maintaining both pricing and total commitments across the existing syndicate. After quarter end, we completed a new 5-year unsecured notes issuance totaling $350 million at a coupon of 6.10%. This issuance was completed in advance of the upcoming February 2027 maturity, which has a $425 million outstanding notional. Overall, we remain confident in the strength and positioning of our debt profile through the remainder of 2026 and into 2027. During the period, we repurchased approximately $12.5 million of our shares at prices below NAV, leaving significant capacity remaining on our $100 million share repurchase program we refreshed earlier this year. Regarding distributions, we paid a $0.45 regular distribution in the second quarter. Additionally, our Board of Directors declared a $0.45 per share regular distribution for the third quarter of 2026 payable to shareholders of record as of September 30, 2026. Our spillover income was approximately $0.86 per share. With that, operator, please open the line for questions.

[Operator Instructions] And the first question will come from Finian O'Shea with Wells Fargo Securities.

Want to ask about the Bridgepointe credit you highlighted. Can you hit on how common is that is for you to lead agent and so forth? Like what portion of the portfolio is in that category? And given it was a more sort of vanilla type spread, like how competitive it was and how you were able to win that?

Yes, Fin, thanks for the question. To answer the first piece, about 15% to 20% of the portfolio at large is agented business. Entirety of the portfolio is lead business. We don't have an agent-only model, but certainly from a visibility and an active involvement perspective, I think that speaks to the entirety of the portfolio. This is one we highlighted just given the migration in the role, which I think speaks to the improved visibility and presence in the marketplace more broadly. I don't know, Jeff, if there's anything more specific on Bridgepointe that you'd highlight.

Yes. Fin, we have a lot of experience in the sector more broadly. And we were able to leverage our experience here in the sector as well as the firm from just a refreshed due diligence perspective, which obviously was helpful for us in gaining conviction to provide financing here. And again, our ability to speak for a more sizable commitment in the transaction enabled us to take over the administrative agency transaction on this.

Great. It's helpful. I think you talked to this or around it a little bit. But with NOI at the dividend, are there levers to build a little cushion on that? Or will you run here? And is this something you're sort of visiting?

That's on NII more broadly. I missed the beginning of it.

Yes, just NII and regular dividend coverage.

Yes. So I think the $0.02 of contraction in the quarter reflected a few headwinds. I can give you maybe a little bit more color to what David outlined earlier, but you essentially had $0.03 of JV accretion that will continue to be a story. That was $0.02 of incremental versus what we saw booked in the first quarter. Offsetting that, you had the uptick in financing costs, in part driven by the fact that we ran at higher average leverage over the course of the quarter. And then a couple of credit-related components in terms of foregone income associated with the new nonaccruals. And on the expense side, less of a lower effective -- a higher effective incentive fee with the look back having a smaller impact in the second quarter. So as we think about the go-forward, we've got to assume that the re-rate of the debt expense is more or less here to stay. Credit is obviously uncertain as some of these new nonaccruals are restructured, income comes back online. Maybe you got the offset with the incentive fee as our lookback kicks in. And then, of course, the accretion from the JV as we look to continue to build that. All told, we continue to feel pretty good about the foundation of NII and the read-through around the distribution as we look to the quarters ahead.

And the next question will come from Melissa Wedel wit UBS.