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The private capital industry’s problems are far worse than Wall Street has acknowledged, as traditional metrics obscure weaknesses in the leveraged buyout market, according to a top credit hedge fund.
A “substantial portion” of the private equity industry is already “stressed or distressed”, said Tony Yoseloff, managing partner and chief investment officer at credit hedge fund Davidson Kempner Capital Management.
“You’re not looking at a problem five years from now, you’re looking at a problem that exists today.”
In new research to be published on Monday, the hedge fund, which manages more than $38bn of assets, gives a broad diagnosis of growing risks in the private capital industry, and why it soon expects buyouts from the last decade to crack. The hedge fund argues excessive leverage, weak cash flows and loose debt contracts have converged to create a ripe environment for corporate defaults.
Davidson Kempner is among the hedge funds positioning to make a fortune if private credit is forced to dump assets. Once the hottest asset class on Wall Street, private credit has come under intense pressure in recent weeks as nervous retail investors have begun to withdraw billions of dollars from semi-liquid funds.
Founded in 1983 by Marvin Davidson who was joined a year later by Thomas Kempner, the hedge fund is known on Wall Street for finding savvy ways to make money from corporate blow-ups. It made nearly $3bn from the collapse of Lehman Brothers.
Davidson and Kempner have since retired, and Yoseloff took over as the sole managing partner in 2020. That same year, the hedge fund financed a handful of restructurings — including retailers Neiman Marcus and J. Crew — brought on by the pandemic.
Aside from that brief bout of bankruptcies in 2020, there have been relatively few chances for investors that specialise in troubled companies to make money in the US over the past decade.
Corporate stress has been evident “for the last couple of years” even with a relatively strong economy and leveraged loan market, Yoseloff said. “Imagine a world where some of those things aren’t as true, and you still have the same issues that sit in the credit system.”
Yoseloff, who joined Davidson Kempner in 1999, said that widespread problems existed in the US credit market even before recent fears surfaced about how AI could upend the software industry, and the exposure private credit had to these companies.
Private equity has gone to extreme lengths to generate returns even as firms have struggled to exit investments, turning to secondary fund sales and continuation funds to make distributions to investors. The industry’s proliferation of roll-ups of mom-and-pop businesses like car washes and insurance brokerage firms has also had mixed results.
These groups had a record backlog of almost $4tn in unsold investments last year, even as dealmaking began to make a comeback, according to a recent report from consultancy Bain & Company.
Yoseloff thinks those firms are in a particularly precarious position, with high leverage, delayed restructurings and difficulty selling companies. When asked if some private equity firms would simply be forced out of business in the coming years due to poor fundraising, he said that was “almost unquestionably true”.
“You don’t need to get to all of the problems of software lending to have a problem,” he said. “The base problem is the rise of interest rates, the lack of growth and profitability of these companies and the inability for sponsors to monetise them.”
He added that recent fears around software were “completely rational”. “There were way too many suspect loans that were made when interest rates were lower,” he said, adding that “the math just doesn’t work” in an environment with higher interest rates.
Private equity software deals from 2019 to 2022 are at particular risk, he said, with most of them already having “eaten their entire equity cushion” since they were bought. “Software [valuation] multiples have come down dramatically,” he said. “Once you lose multiple, it’s really hard to get it back.”
Similar problems have begun to form in private credit. Borrowers are more frequently opting to increase their principal balance instead of paying cash, known as “payment-in-kind” or PIK, which has staved off defaults. Davidson Kempner estimates that there is $768bn of stressed debt in the US leveraged loan and direct lending markets.
The hedge fund also raised concerns around interest coverage ratios, a measure of a company’s ability to service its debts with the profits it generates. The proportion of companies where this ratio was below 1.5x — a level that indicated stress — has more than doubled since 2019.
In the new research, it said opportunities are “just beginning” to surface for investors that specialise in distressed investments. Suzanne Gibbons, partner and head of research at Davidson Kempner, said the hedge fund has so far bought debt from private lenders in one company and taken it over through a restructuring. The firm is already working on another.
“We certainly haven’t seen fire sales” in private credit, she said. “We’re in the first inning.”
Additional reporting by Sujeet Indap, Eric Platt and Antoine Gara
