Chekhov’s gun: Incentives and accountability in semi-liquid private credit

Charlie Munger once said: "Show me the incentive and I will show you the outcome."

Semi-liquid private credit funds are a clear example of both causation and inevitability. Traditional institutional private credit largely operated under a relatively straightforward arrangement. LPs committed capital. Fees were charged on committed capital and later, on invested capital. GPs earned a promoted interest only after investors received a return of capital and returns exceeded a hurdle rate. The fund had a beginning and an end. Valuations mattered, but the GP's economics were not directly dependent upon quarterly changes in NAV. Nor were investor returns predicated on controlling the timing of their exit.

Then semi-liquid vehicles entered the wealth channel. The industry wanted a structure more compatible with individual investors and advisers. Perpetual funds were adopted so capital could flow in continuously, investors could redeem on an ongoing basis, and assets could run indefinitely. But the structure introduced a new set of incentives whose consequences would emerge over time. The gun had been placed on the wall.

In a traditional institutional fund, the GP eventually realizes gains and receives a promote when assets are sold profitably. In a perpetual vehicle, there is no natural liquidation event, and the economics evolved accordingly. Management fees became tied to NAV. Performance compensation became linked to periodic changes in value. The incentive structure changed, however, the accountability framework largely did not – there lies the origin of the tension visible today. Chekhov put it plainly:

“If there is a gun hanging on the wall in the first act, it must go off in the third”.

In public markets, prices are established through arm’s length transactions on exchanges, visible to all participants and regulated by independent bodies. Accountability is built into the mechanism itself. In a perpetual private vehicle, no such mechanism exists. NAV is not proven, it is determined. And increasingly, the economics surrounding that determination matter.

In most perpetual private vehicles, the investment manager, the firm managing the assets and earning fees based on NAV, retains overwhelming influence over the valuation process. Third-party valuation firms provide inputs. Independent boards provide oversight. But in practice, the investment manager often assembles the methodology, selects comparables, applies adjustments, and influences the result. The relevant question is not whether independent parties participate, but who has final responsibility for the number. When a firm earning a 1.25% management fee on NAV also has control over what that NAV is, the process becomes a form of supervised self-assessment in which oversight exists, but the economic incentives remain concentrated and conflicted. The valuation framework inherited from institutional funds remained substantially intact, but its purpose has fundamentally changed.

Historically, LPs have viewed this as less problematic because NAV primarily served a reporting function. Today it serves a much larger purpose. It determines management fees, performance fees, subscription pricing, redemption pricing, and ultimately investor outcomes. It is no longer simply a reporting measure; it has become an economic and transactional focal point; one produced by a process designed for a different era and applied to a structure with entirely different incentives.   

From the perspective of the financial advisor and the investor in a semi-liquid fund, it is entirely different. A financial advisor may see publicly traded markets for similar assets reprice downward while the reported NAV of a semi-liquid vehicle has moved less or not at all, or a similar loan portfolio held in an exchange vehicle trading at a steep discount. The question becomes unavoidable: should I buy or redeem at the current price? The investor now possesses a redemption mechanism unavailable in traditional institutional structures. If the advisor concludes that the redemption price exceeds underlying economic value, redeeming is not only a rational decision but a responsible one. This is not panic or irrationality. The structure itself has delegated that judgment to the investor and his/her advisor. It doesn’t make sense to critique them for exercising that option.

This is why I have publicly argued that third-party valuation firms should be deemed experts for purposes of valuation and provide independent values for the underlying loan portfolio. That accountability would improve not just the independence of the marks but would require the valuation process to incorporate the public market signals that investors are already responding to. It would likely eliminate suspicion around accounting treatments that lead to NAV recognition that doesn’t reflect underlying fundamentals. Boards, working with advisors and reviewing the broader balance sheet, leverage, reserves, liabilities, and other considerations, could then determine the final NAV.  It is worth noting that non-traded REITs, a comparable perpetual vehicle structure designed for individual investors, have long required independent valuation advisors and third-party appraisers to determine asset values. While imperfect, it represents a higher standard of accountability than currently exists in private credit semi-liquid funds. The private credit industry adopted the perpetual structure but did not import the valuation governance that comes with it.

If private credit investment managers continue to hold firm on the notion that everything is fine and outside influences are to blame for redemptions and slowing new investor allocations, we will see a continuation of the current environment for longer than they believe.

The investment manager sets the price at which you buy and the price at which you sell and earns fees on the price they influence in between. Who other than the investment manager bears the responsibility when elevated redemptions and slowing new capital allocations are the outcome?

Mark Goldberg is the founder of Alternative Investments Market Intelligence (AltsMI.com). He has served as chief executive officer of investment management and broker-dealer firms and received the Institute for Portfolio Alternatives’ Lifetime Achievement Award for his contributions to the wealth management industry. Through AltsMI.com, Mark publishes the Alts Leaders Survey and research on private-market adoption in the wealth channel. His commentary and published research are widely read, and he is a featured speaker at industry events.