📝 The AGM Q&A with Davidson Kempner's Tony Yoseloff and Suzanne Gibbons - opportunities in credit amidst a capital structure reset?
Conversations with private markets leaders
Davidson Kempner’s heritage lies in cutting through complexity to find value.
Founded in 1983, Davidson Kempner’s origins began in merger arbitrage, distressed debt, and opportunistic credit. The firm, which now has around 1,800 clients, began accepting outside capital in 1987 and has since built out its investment platform to include convertible arbitrage, long / short equities, asset-based lending, and real estate strategies.
Davidson Kempner has since grown to almost $40B in AUM across public and private markets strategies.
The firm has a penchant for navigating complex situations across public and private markets to opportunistically uncover value, noting that “no situation is too complex for [them].”
In this edition of the AGM Q&A, we had the chance to sit down with Davidson Kempner’s Managing Partner and Chief Investment Officer Tony Yoseloff and Partner and Head of Research Suzanne Gibbons to discuss the impacts of a “higher-for-longer” rate environment and what that means for private credit, private equity, and the opportunities in opportunistic credit.
Please enjoy this Q&A with Tony and Suzanne, who have a wealth of knowledge about the nuances of credit, navigating complexity across public and private markets, and where to find value in market dislocations.
Opportunities in credit amidst a capital structure reset?
Q: You have said recently that we are “in the early innings of a capital structure reset.” What do you mean by this?
We use that phrase to describe the lagged impact of the transition from the zero interest rate policy (ZIRP) era to today’s higher-for-longer rate environment. During ZIRP, many companies — particularly those owned by private equity firms — were able to sustain elevated leverage through low borrowing costs, optimistic growth assumptions, and financial engineering. That environment has changed significantly.
Today, we’re seeing the consequences emerge. Leverage remains elevated, but interest coverage ratios have deteriorated, and a growing portion of the credit universe is operating with stressed capital structures. At the same time, private equity portfolios are aging with longer holding periods and more capital tied up in unrealized investments.
Sponsors have responded by employing “time-buying” tools such as payment-in-kind (PIK) interest and liability management exercises (LMEs). These can delay restructurings but often do not solve underlying issues — many of these situations ultimately result in default or bankruptcy.
Taken together, these dynamics suggest that we are still early in the process of balance sheet repair. Companies have not fully adjusted to the new cost of capital, and the need for restructuring and recapitalization is likely to increase.
Q: How are private equity and private credit interconnected in your view, and how should investors approach the current investment opportunity set from a credit perspective as a result?
Private equity and private credit are tightly linked because much of the credit opportunity set originates from private equity-owned companies.
Over the past decade, the growth of private equity has driven a parallel expansion in leveraged credit, including direct lending. Today, however, the dynamics are diverging. Private equity faces structural headwinds – higher rates, elevated purchase multiples, and capital saturation – which are likely to compress forward returns.
At the same time, a meaningful portion of private equity capital is underperforming. In our latest white paper, our analysis shows that approximately 21% of deployed capital since 2015 is tracking below an 8% hurdle rate.
From our perspective, this is where opportunistic credit comes in. Many of these companies remain viable but require capital solutions that will address their liquidity constraints, extend maturities, or restructure balance sheets. In our view, that creates a growing opportunity set for credit investors who can provide flexible and/or bespoke financing.
Importantly, the supply-demand dynamic is favorable. The opportunity set is expanding while dedicated opportunistic credit capital remains relatively small – about $640 billion globally, or roughly 7% of private equity capital.
As a result, we believe credit — particularly opportunistic credit — is increasingly a source of alpha. In our view, opportunistic credit should not be viewed as a defensive allocation in this environment.
Q: In your view, how much of the issues in the US credit market, and specifically the direct lending market, are due to what some seem to think are issues with SaaS companies and how AI may negatively impact these companies?
Davidson Kempner takes a broader view. While certain sectors may face disruption, the primary drivers of stress in credit markets are structural and macroeconomic, not sector-specific.
We believe the key issues are elevated leverage, higher borrowing costs, and underwriting assumptions made during the ZIRP era. For example, the growing use of EBITDA add-backs has often masked true leverage, leaving companies more levered than headline metrics suggest.
At the same time, rapid growth in direct lending has increased competition, leading to looser documentation and more aggressive terms. Recovery rates have declined while liability management activity has increased.
More broadly, smaller companies – regardless of sector – are more exposed to these pressures due to tighter liquidity, greater sensitivity to borrowing costs, and less flexibility to manage through economic and operational shocks. As a result, they have been more impacted by the higher rate environment and ongoing uncertainty, with defaults for smaller companies rising to nearly 13% – more than 3x the rate for larger companies.
In our view, while technology trends may impact individual businesses, the broader challenges in credit markets are primarily the result of capital structures built in a very different rate environment.
Q: In a recent white paper, you shared data on PE funds since 2015 that are tracking below an 8% hurdle rate. The whitepaper finds that approximately 21% of deployed capital falls into this category, which could suggest that around $1.4T of PE capital might be below hurdle. What does this mean for the opportunity set in opportunistic credit?
We believe this is one of the clearest indicators of the scale of the opportunity.
Applying that 21% figure to the approximately $6.7 trillion of global deployed private equity capital suggests that up to $1.4 trillion may be underperforming and largely out of capital – more than 2x the size of the opportunistic credit market.
In practice, this means a significant portion of the private equity ecosystem may not have the capital — or in some cases, the incentive — to support underperforming portfolio companies. As a result, these companies will increasingly need external capital to stabilize their balance sheets.
For opportunistic credit investors, we believe this creates a wide range of opportunities, including:
Providing rescue financing.
Purchasing discounted debt and leading restructurings.
Structuring capital solutions for downside protection and equity upside.
An important caveat: many of these businesses are not fundamentally broken — they are simply over-levered. That distinction is key to generating attractive risk-adjusted returns, in our view.
Q: Your recent whitepaper notes that default rates for U.S. direct lending borrowers with EBITDA below $25 million have risen materially to nearly 13% more than three times those of larger issuers. Does this mean that investing activity in opportunistic credit will focus largely on the lower middle-market?
Not necessarily. While the lower middle market is clearly experiencing more acute stress — and therefore presents meaningful opportunities — it is only one part of the broader landscape.
The data shows that smaller companies are more vulnerable in the current environment, with default rates significantly higher than those of larger issuers. This reflects more limited access to capital and greater sensitivity to higher rates.
However, opportunities in opportunistic credit are driven less by company size and more by complexity and dislocation. Larger companies — particularly those with aggressive capital structures or roll-up strategies — are also facing meaningful challenges.
In addition, the opportunity set spans multiple strategies, including secondary purchases of discounted debt, capital solutions for sponsor-backed companies, and larger-scale restructurings.
While the lower middle market is an important segment, opportunistic credit is best understood as a broad, cross-market opportunity set.
Q: What are some more nuanced opportunities in opportunistic credit, such as infrastructure assets or the credit investing opportunity in Europe?
Two areas that stand out to us are (1) special situation infrastructure assets, and (2) Europe.
On the infrastructure side, we’re seeing opportunities in carve-outs of non-core assets. These transactions often involve stable cash flows under long-term contracts and can offer attractive risk-reward profiles — combining downside protection with operational upside.
In Europe, we believe the opportunity is driven by credit contraction. Bank lending to corporates has declined relative to GDP, particularly in more complex situations requiring bespoke financing. At the same time, Europe remains heavily bank-dependent, which amplifies the impact of this retrenchment.
In Davidson Kempner’s view, this creates a structural mismatch between improving fundamentals and constrained credit supply — especially in parts of Southern Europe — resulting in attractive opportunities with less competition.
Q: What role should opportunistic credit play in a portfolio? Where do investors bucket opp credit and are they re-allocating from other parts of their credit allocation or taking from their private equity allocation?
Opportunistic credit plays a unique role because it does not fit neatly into traditional asset class buckets. We view this as a competitive advantage — opportunistic credit’s flexibility is a key source of its value.
From a portfolio construction perspective, opportunistic credit can enhance efficiency by delivering attractive returns with lower volatility and lower correlation to public markets. In a representative 70/30 portfolio, including opportunistic credit in a portfolio improved returns by roughly 40 basis points at the same level of risk.
In terms of allocation, investors often debate whether to fund it from credit or private equity. Increasingly, we see that portion being funded from private equity. That is because opportunistic credit shares many of the same characteristics as private equity — complexity, illiquidity, and sourcing — but offers a different risk-return profile, including stronger downside protection and more consistent cash flows. At the same time, forward private equity returns are likely to be lower than historical averages due to structural headwinds.
Put simply, reallocating a portion of private equity exposure toward opportunistic credit can help build a more balanced and resilient portfolio.
Disclaimer: Alt Goes Mainstream is an independent newsletter focused on the private markets industry. It is published for informational and educational purposes only and does not constitute investment advice, financial advice, legal advice, or any other form of professional advice. Nothing contained herein should be construed as a recommendation to buy, sell, or hold any security or investment product. Some companies, individuals, or organizations featured or mentioned in this newsletter may be current or past sponsors of Alt Goes Mainstream. Sponsorship does not influence editorial coverage, but readers should be aware that a relationship might exist. The author may hold direct or indirect investments in companies, funds, or other entities mentioned in this newsletter.
The funding-source point is what I find interesting. Family offices I talk to are increasingly funding opp credit from the PE bucket rather than the credit bucket, which quietly changes how they think about the J-curve and downside on the rest of the alts sleeve. Curious whether you've found those LPs need different reporting or framing than your traditional credit-bucket allocators.