Vultures are coming! Top hedge funds: Wall Street underestimated the problems of "private credit," "acquisition deals from the past decade will soon fail"

Top hedge fund Davidson Kempner, managing over $38 billion in assets, issues a warning: Problems in the private capital industry are far more severe than Wall Street admits, and we are already in a crisis, not just facing distant concerns.

Partner and Chief Investment Officer Tony Yoseloff stated that a “significant proportion” of companies in the private equity sector are under “pressure or distress.” “You’re not facing a problem five years from now, but one that already exists today.”

In its latest research report released this Monday, Davidson Kempner pointed out that the combination of high leverage, weak cash flows, and lenient debt covenants has created mature conditions for a wave of defaults.

Behind this report is Davidson Kempner’s active positioning—if private credit assets are forced to be sold off, the fund stands to profit. Private credit was once one of Wall Street’s hottest asset classes, but in recent weeks, it has come under clear pressure, with tense retail investors beginning to withdraw billions from semi-liquid funds.

The problem is now in plain sight: the triple risks of leverage, cash flow, and software loans

Davidson Kempner estimates that there is up to $768 billion of stressed debt in the U.S. leveraged loan and direct lending markets. Yoseloff noted that even in a relatively strong economy with a stable leveraged loan market, corporate stress has been clearly visible “over the past few years.” “Imagine if these favorable conditions no longer hold, and problems persist in the credit system—what would happen?”

Regarding specific risk exposures, private equity software deals completed between 2019 and 2022 are identified as high-risk areas. Yoseloff said that most of these deals have “exhausted all equity buffers” since their acquisitions, and software industry valuations have been significantly compressed. “Once the valuation multiples are lost, it’s hard to regain them.” He added that recent market concerns about AI’s impact on the software industry are “completely reasonable,” noting that “too many questionable loans were issued when interest rates were low, and in a high-rate environment, this situation is unsustainable.”

Meanwhile, more borrowers in the private credit market are opting for “payment-in-kind” (PIK)—using increased principal balances instead of cash payments—to delay defaults. The fund also expressed concern over interest coverage ratios: the proportion of companies with an interest coverage ratio below 1.5x (a warning threshold) has more than doubled since 2019, indicating rising financial stress.

Vultures are entering: Opportunities “just beginning,” “we’re still in the first inning”

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

Today, the fund is turning its attention to potential private credit sell-offs. Partner and Head of Research Suzanne Gibbons said that they have already purchased debt from a private loan provider and completed a takeover through restructuring, with another deal in progress. “We haven’t seen a fire sale in private credit yet,” she said, “we’re still in the first inning.”

Regarding the outlook for the private equity industry, Yoseloff was direct: some private equity firms are being forced to exit the market due to fundraising difficulties, which is “almost undoubtedly” the case. He summarized the core issues into three points—rising interest rates, lack of growth and profitability in portfolio companies, and investors’ inability to exit smoothly. According to a recent Bain & Company report, the unexited investments in private equity last year approached a record $4 trillion.

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