The core mechanism: when buyers cannot observe quality, they price at the average quality. High-quality sellers receive below-value prices and exit. The remaining pool is lower quality on average, so buyers lower their price. The next tranche of higher-quality sellers exits. The market converges on the lowest-quality pool — or collapses entirely.
| Mitigant | Mechanism | Capital-Markets Example |
|---|---|---|
| Signalling | High-quality sellers incur a credible cost that low-quality sellers cannot mimic — proving quality through action | Audited financials, GP co-investment, seller retention tranches in CLOs, lockup periods, rep-and-warranty insurance |
| Screening | Buyers impose information requirements that reveal quality before transacting | Data-room standards, due diligence checklists, GP-led continuation-fund disclosure packages, credit-bureau pulls |
| Pooling | Mandatory or near-mandatory participation forces good risks into the pool, cross-subsidizing bad risks and preventing unraveling | Employer-sponsored health insurance, government-backstopped flood insurance, ACA individual mandate (now weakened) |
Worked example — GP-led continuation funds. A PE sponsor wants to hold a portfolio company past the fund's term by moving it into a new vehicle. LPs who decline the roll get liquidity (they 'sell'). LPs who roll continue alongside the GP. Adverse selection concern: the GP knows the company better than new LP investors do. If the GP is rolling primarily because the exit market is thin or the asset needs more work, new LP investors may be buying the 'lemons' the GP couldn't sell at a fair price. Mitigants: fairness opinion from an independent advisor, secondary-market pricing as a benchmark, co-investment by the GP on the same economic terms as new LPs.
Sit with the ideas.
A voluntary health-insurance market allows individuals to opt in or out based on their own health expectations. The insurer prices premiums at the average expected cost of the population. Over several years, what is the most likely outcome?