The vultures are here! Top hedge funds: Wall Street has underestimated the problems with “private credit,” and acquisition deals from the past decade will soon collapse.

Davidson Kempner, a top credit hedge fund managing over $38 billion in assets, has issued a warning: The problems in the private capital industry are far more severe than Wall Street admits; it is currently a crisis, not a distant concern.

Tony Yoseloff, the fund’s managing partner and chief investment officer, said that a “substantial proportion” of companies in the private equity industry are in a state of “stress or distress.” “What you’re facing is not a problem five years from now, but one that already exists today.”

Davidson Kempner’s latest research report, released this Monday, pointed out that the combination of excessive leverage, weak cash flow, and loose debt covenants has now set the stage for a wave of corporate defaults.

Behind this report is Davidson Kempner’s active positioning—once private credit is forced to sell off assets, the fund stands to profit. Private credit was once one of Wall Street’s hottest asset classes, but has come under obvious pressure in recent weeks, with nervous retail investors starting to pull out billions from semi-liquid funds.

Problems are at hand: The triple risks of leverage, cash flow, and software loans

Davidson Kempner estimates that there is as much as $768 billion in stressed debt in the U.S. leveraged loan and direct lending markets. Yoseloff noted that even in a relatively robust economy with a fairly stable leveraged loan market, corporate stress has been clearly visible "over the past few years." “Just imagine what would happen if these favorable conditions no longer exist, while problems in the credit system persist.”

In terms of specific risk exposure, private equity software deals completed between 2019 and 2022 have been singled out as a high-risk area. Yoseloff said that most of these deals have “used up all equity buffers” since acquisition, and valuation multiples in the software sector have been substantially compressed; “once you lose the valuation multiple, it’s very hard to recover it.” He added that recent concerns about AI’s impact on the software industry are “completely reasonable,” and “too many questionable loans were made when interest rates were low; in a high-rate environment, the numbers simply don’t add up.”

Meanwhile, borrowers in the private credit market are increasingly opting for “payment-in-kind” (PIK)—that is, increasing principal balance in lieu of cash payment—as a way to delay default. The fund also voiced concern over interest coverage ratios: the share of companies with a ratio below 1.5 (the stress warning level) has more than doubled since 2019, in this indicator measuring a company’s ability to service debt from operating profits.

Vultures Enter the Arena: The opportunity has "just begun," "we’re only in the first inning"

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

Now, the fund is focusing on the potential sell-off opportunities in private credit. Fund partner and head of research Suzanne Gibbons said, they have already bought a company’s debt from private lenders and taken control through restructuring, and another deal is underway. "We haven’t seen fire sales in private credit yet," she said, "we’re still in the first inning."

Regarding the outlook for the private equity industry, Yoseloff was blunt: Some private equity firms will be forced to exit the market due to fundraising difficulties, which is "almost a certainty." He attributed the core problems to three factors—rising interest rates, lack of growth and profitability at portfolio companies, and investors’ inability to exit smoothly. According to a recent Bain & Company report, the backlog of unsold investments in the private equity industry reached nearly a record $4 trillion last year.

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