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

Why does AI · Buzzard Fund believe the crisis opportunity is just beginning?

Top credit hedge fund Davidson Kempner, managing over $38 billion in assets, warns that problems in the private capital industry are far more severe than Wall Street admits, and we are currently in a crisis, not just a distant worry.

Managing partner and chief investment officer Tony Yoseloff states that a “significant proportion” of companies in the private equity industry 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 points out that the combination of high leverage, weak cash flow, 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 expects to profit from it. Private credit was once one of Wall Street’s hottest asset classes, but in recent weeks, it has come under significant pressure, with tense retail investors beginning to withdraw billions from semi-liquid funds.

The problem is clear: the triple risks of leverage, cash flow, and soft 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 notes 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 states that most of these deals have “exhausted all equity buffers” since acquisition, and software industry valuations have been significantly compressed. “Once the valuation multiples are lost, it’s hard to recover.” He adds 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 choosing “payment-in-kind” (PIK)—using increased principal balances instead of cash payments—to delay defaults. The fund also expresses concern about interest coverage ratios: the proportion of companies with an interest coverage ratio below 1.5x (a warning threshold) has more than doubled since 2019.

Vulture entering: opportunity “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 COVID-19 pandemic.

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

Regarding the outlook for the private equity industry, Yoseloff is straightforward: some private equity firms are being forced to exit the market due to fundraising difficulties, which is “almost undoubtedly” the case. He attributes the core issues to three factors—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.