Private Credit is a Market for Lemons

On Sept. 28, Kurt Hohl, the SEC's chief accountant, and Brian Daly, director of its Division of Investment Management, published a staff statement on fair value measurement and disclosure considerations for private assets. It describes a market where loans generally carry no quoted prices, marks rest on management's own unobservable inputs, and boilerplate disclosure can leave investors without the context to judge either.

A Market for Lemons

George Akerlof won a Nobel Prize for his 1970 paper, "A Market for Lemons," where he modeled a used car lot with two kinds of sellers: those with functional cars (peaches) and those with defective cars (lemons). Previous owners, having driven their cars, know what they're worth; buyers are guessing. Faced with uncertainty, buyers price in the risk of buying a lemon. Call that discount the lemons premium. For sellers of functional cars, the new market price, after subtracting the lemons premium, falls beneath what the car is actually worth. Selling is not worth it, so they walk away.

When a functional seller leaves, the composition of the remaining pool gets worse. The probability of being sold a lemon goes up. Buyers notice and adjust, and the lemons premium increases. More functional sellers leave. The cycle continues until lemons are all that's left.

This is an adverse selection problem. Whether a car is functional or defective is private information held by the seller. Price is the only public signal. And when price fails to separate quality from junk, the market fails with it.

Private Credit Is a Used Car Lot

In the $1.7 trillion private credit industry, fund managers make a living raising money from investors and lending it out, and each deal carries bespoke terms. Because each loan is unique, there is no exchange and no price discovery mechanism available to outsiders. Fund managers mark their own portfolios to market, and they do so with plenty of wiggle room for interpretation of market conditions and assumptions. Investors are left relying on the honor system and brand reputation.

Now put yourself in the shoes of the fund manager. Your compensation follows the industry standard: 2 and 20. The "2" is a 2% annual management fee on assets under management, collected regardless of performance. The "20" is a 20% carry on profits above a hurdle rate, collected only if the fund actually makes money.

Assume you are a cynic, or a nihilist, or both. You understand that beyond a baseline of competence, the performance of your fund is largely out of your control. An untimely tariff shock, a war, or a credit cycle shift will move your returns more than any single investment decision you could make. You conclude that your carry is a function of the market and that the market is a random walk. So you focus on what you can control: the management fee.

Naturally, as a rational manager, you raise as much capital as possible. A 2% fee on $500 million pays better than 2% on $100 million regardless of what happens to the underlying loans. Second, you mark your portfolio as high as you can justify. Higher marks mean higher reported assets, which means higher fees and an easier fundraise for your next vehicle. Third, you delay writing off bad investments for as long as possible. Every quarter you avoid recognizing a loss is another quarter of fees on phantom assets. Fourth, you launch Fund II and Fund III before you have to return money to investors in Fund I. While you are out raising, the last thing you want is to admit mistakes. Lastly, because you are an optimizer, you spend your time on whatever increases your next paycheck the most: fundraising. The actual investment decisions get delegated to junior staff with less skin in the game.

None of this requires fraud. It requires only that the incentives point one way and that nobody outside the fund can check the marks. John Zito, co-president of Apollo's asset management arm, told clients in March, "I literally think all the marks are wrong." That is the lemons dynamic in a $1.7 trillion market. Every fund reports smooth returns. You cannot verify the underlying marks. Most fund managers have no incentive to change that.

The SEC staff saw the same problem. The Sept. 28 statement calls private credit loans individually negotiated assets that generally lack readily available quoted prices, measured with unobservable inputs the manager selects. The staff flagged boilerplate and overly aggregated disclosure, called out non-accrual status and PIK interest as things that might not be readily apparent from high-level portfolio statistics, and noted that the NAV practical expedient can produce a mark that differs from what a sale would actually realize. The reminder is pointed.

Marc Rowan Wants You to Know He Has Peaches

Marc Rowan, Apollo's CEO, has said the private credit industry needs to learn "a whole new set of skills." He wants daily NAV reporting, third-party valuations, and real price discovery across Apollo's credit funds.

If you run a clean book with performing assets, obscurity is your enemy. A peach salesman in a market for lemons has exactly one rational move: show the fruit. Daily NAV is a signaling mechanism. It says: look at our portfolio, we are not afraid of what you will find. Apollo is looking to capitalize on market panic and land investors fleeing less transparent funds.

Think of heads-up poker. When you play with your cards exposed, information asymmetry disappears and the game becomes solved. Apollo only does this because they hold strong cards and they know the rest of the table is weak. But once the table is open, you cannot go back to playing blind. Other players will be forced to show their hands too. The game is changing permanently.

Redemption Panic

Most private credit funds are illiquid aside from some form of periodic redemption window, usually capped around 10% of the fund. During a market downturn, every investor in the fund faces a choice: stay in and hope the fund is a peach, or redeem and protect yourself in case it is a lemon.

The fund manager will tell you the assets are fine. But you would be unwise to take their word for it. They grade their own homework. So the rational move is to redeem. If the fund turns out to be fine, you can always reallocate later. If it is not fine, you want to be first out the door. The cost of being wrong about a functional fund is low, but the cost of being wrong about a defective one is catastrophic.

But if everyone reasons this way, even a perfectly healthy fund faces a liquidity crunch. Each investor acts in self-interest and the collective outcome is worse for everyone. This is Akerlof's market running in reverse: in his lot, functional sellers left because buyers could not verify what they were selling, and in private credit, investors redeem from functional funds because they cannot verify what they are holding.

Transparency Restores the Missing Signal

The missing signal is the loan book itself. If investors could examine a fund's loans directly and see each payment, default, and mark as it occurs, the redeem-first logic above stops applying. An investor in a fund with performing loans can see that they perform and stays in. An investor in a fund with troubled loans sees the trouble early enough to manage exposure before losses grow.

When a publicly traded company misses a coupon payment, the information propagates in seconds. Every Bloomberg terminal on every trading desk displays the same update, and the bond reprices.

Private credit can have that information environment without becoming public credit. What investors need is loan-level data they can verify independently: payment histories, covenant compliance, marks backed by something other than the manager's own spreadsheet. The SEC's statement asks managers to mark well and disclose more, but everything it asks for still travels through the manager's own filings and the auditor's periodic sign-off, so the investor is still taking the manager's word. Rowan seems to understand this. Apollo, as the largest private credit manager in the world, is positioned to set that standard, and competitors will follow because investors will prefer funds they can check. Akerlof's functional sellers left the used car market because they had no way to prove what they had. A private credit manager with a clean book can publish the same proof, in loan records investors can verify directly.