The vultures are coming! Top hedge funds: Wall Street underestimates the issues with "private credit," and "acquisitions from the past decade will soon fail"

Top credit hedge fund Davidson Kempner, which manages over $38 billion in assets, has issued a warning: the problems facing the private capital industry are far more severe than Wall Street admits—this is already a crisis, not a distant concern.

Tony Yoseloff, Managing Partner and Chief Investment Officer at Davidson Kempner, stated that a “significant proportion” of companies in the private equity industry are “under stress or in distress.” “What you’re dealing with isn’t a problem five years out—it’s an issue that already exists today.”

In its latest research report released on Monday, Davidson Kempner pointed out that the combination of excessive leverage, weak cash flow, and loose debt covenants has created ripe conditions for a wave of corporate defaults.

Behind this report is Davidson Kempner’s active positioning to profit if private credit is forced to liquidate assets. Private credit was once one of Wall Street’s hottest asset classes, but has come under significant pressure in recent weeks, as nervous retail investors have begun withdrawing billions of dollars from semi-liquid funds.

Problems Are at the Doorstep: The Triple Threat of Leverage, Cash Flow, and Software Loans

Davidson Kempner estimates that there is as much as $768 billion in stressed debt within the U.S. leveraged loan and direct lending markets. Yoseloff noted that even in a relatively strong economy, with a still-stable leveraged loan market, corporate stress has been “clearly visible over the past few years.” “Imagine what would happen if these favorable conditions disappear, yet the issues within the credit system persist.”

As for specific risk exposure, private equity software deals completed between 2019 and 2022 were singled out as high-risk areas. Yoseloff stated that most of these deals have “used up all their equity cushion” since their acquisition, and that valuation multiples for the software sector have compressed significantly. “Once you lose valuation multiples, it’s very hard to get them back,” he added. Recent market worries about the impact of AI on the software industry are “completely reasonable,” he noted. “Too many questionable loans were issued when rates were low—those numbers just don’t add up in a high-interest-rate environment.”

Meanwhile, more and more borrowers in the private credit market are opting for “Payment in Kind” (PIK) — meaning they are replacing cash repayments with increases in principal balance — in an effort to delay defaults. The fund is also concerned about interest coverage ratios: the share of firms with this metric, which measures a company’s ability to service debt through operating profits, below 1.5 times (the stress threshold) has more than doubled since 2019.

Vultures Enter: The Opportunity Has “Just Begun”—“We’re Still in the First Inning”

Davidson Kempner is well-known for profiting from corporate crises. Founded in 1983, the fund earned nearly $3 billion during the Lehman Brothers bankruptcy and provided financing for the restructuring of retailers like Neiman Marcus and J. Crew during the 2020 pandemic.

Now, the fund is eyeing potential forced selling opportunities in private credit. Fund Partner and Head of Research Suzanne Gibbons said, they have already bought the debt of a company from a private lender and taken control through restructuring, and another deal is in progress. “We haven’t yet seen fire sales in private credit,” she said. “We’re still in the first inning.”

Yoseloff is blunt about the outlook for the private equity industry: some private equity firms will be forced to exit due to fundraising woes—“that is almost a certainty.” He attributes the core problems to three factors: rising interest rates, lack of growth and profitability among portfolio companies, and investors’ inability to exit smoothly. According to a recent report by Bain & Company, the backlog of unsold investments in the private equity industry last year approached a record-high $4 trillion.