Direct Lending Does Not Diversify a Private Equity Portfolio

What's New

Middle market direct lending moves with private equity, which makes it a weak defensive counterweight in an equity-heavy portfolio. James Li, President and Partner at Davidson Kempner, argues this in a podcast interview on Alt Goes Mainstream. Direct lenders finance the same companies the sponsors own, one level up the capital structure. Distressed and opportunistic credit run the other way, buying when sponsors and lenders are forced to move assets. Allocators should test whether their credit sleeve diversifies the equity sleeve or duplicates it.

Why It Matters

The move since 2022 has been to fund private credit out of the fixed income allocation and treat it as the defensive bucket. Li's account says that allocation carries the same borrowers and much of the same risk as the private equity book. That puts him against every direct lender selling stability. It also serves Davidson Kempner, which raises opportunistic credit and absolute return products designed to buy from stressed lenders.

Zoom In

Li's proof case is the loan a large direct lender no longer wants to work out. A $100 million position is too small to justify the restructuring effort at the biggest firms. He describes buying it at 70 cents when the lender carries it at 80, then running the workout in house. Davidson Kempner has built an operating partner platform to take control of businesses through the debt. Li puts bite sizes below $500 million in the zone where the largest firms do not compete hard.

Reality Check

No return, volatility, or loss figures for Davidson Kempner appear anywhere in the interview. The correlation claim between direct lending and private equity is asserted rather than demonstrated. The 21% of post-2015 private capital sitting below an 8% hurdle comes from the firm's own white paper. Li concedes the opportunistic product is vintage dependent and says 2024 may not have been the right entry point.

Memorable Quotes

• “I would argue that middle market direct lending is procyclical to private equity and much more correlated to that asset class.” The thesis in one line, and the claim an allocator can test against their own book.

• “If you're a par lender you typically need to have leverage to get to the return stream post fees that investors are expecting.” His explanation of why direct lending returns and credit market stress are linked more tightly than the product suggests.

• “We've tried to design that product to be all weather, but you're going to have great vintages.” A concession that the countercyclical pitch still carries vintage risk, which is the same problem he attributes to everyone else.

• “We're not in the origination business. We're in the repayment business.” The whole posture compressed: value comes from exit and recovery, not from writing the loan.

The Wrap

Davidson Kempner is asking allocators to re-underwrite a sleeve most of them built for safety. The case gets stronger if marks on direct lending books keep drifting and lenders keep selling smaller positions below carrying value, which is the supply the strategy needs. It weakens if sponsors refinance the 2019 to 2021 vintages cleanly and the workout pipeline never materializes. The 2018 to 2022 funds still working to return capital will settle it within a few years.