We show that Schwann cell–derived Desert hedgehog (Dhh) signals the formation of the connective tissue sheath around peripheral nerves. mRNAs for dhh and its receptor patched (ptc) are expressed in Schwann cells and perineural mesenchyme, respectively. In dhh^−/− mice, epineurial collagen is reduced, while the perineurium is thin and disorganized, has patchy basal lamina, and fails to express connexin 43. Perineurial tight junctions are abnormal and allow the passage of proteins and neutrophils. In nerve fibroblasts, Dhh upregulates ptc and hedgehog-interacting protein (hip). These experiments reveal a novel developmental signaling pathway between glia and mesenchymal connective tissue and demonstrate its molecular identity in peripheral nerve. They also show that Schwann cell–derived signals can act as important regulators of nerve development.