As a Professor of Law and Economics at Harvard Law School, as well as former Acting Director for the Division of Corporation Finance for the US Securities and Exchange Commission (SEC), John Coates doesn’t mince his words when it comes to regulating the wildest beasts of modern capitalism. In his latest book, The Problem of 12: When a Few Financial Institutions Control Everything, he explores the origins of a quiet revolution in American finance. ‘Big Four’ index funds such as Vanguard and BlackRock control more than 20 percent of the votes of S&P 500 companies. Private equity firms, the likes of Carlyle and KKR, have amassed trillions of assets while removing from public markets and scrutiny an increasing number of firms. This is the titular ‘problem of 12’: a few financial institutions hold dangerously outsized sway over US politics and finance.
Professor Coates sat with World Finance’s Alex Katsomitros to discuss how we arrived at this crucial juncture and what regulators and policymakers can do about it.
How did index funds and private equity grow so big?
Index funds are growing faster than the economy, the stock market and even the companies they own, because they offer a remarkably good product: a low-cost way to achieve diversified investment in the equity, debt and alternative markets. They have a track record of 50 years of outperforming most active managers, even before fees.
Index funds are growing faster than the economy, the stock market and even the companies they own
It is not simply retail investors who benefit from the product, but most large institutional investors, including pension funds and endowments. They also enjoy enormous economies of scale. That allows them to lower fees even more. Today, you can get close to zero costs.
The combination of growth and concentration coming from economies of scale means that the top index funds now own 25 percent or more of all US-listed companies. Private equity funds are also growing faster than the economy and public capital markets and enjoy enormous economies of scale and access to information. They are constantly buying and selling companies, raising funds, exchanging ownership stakes with other investors.
They also run credit funds. So they are responsible for an excess of 25 percent or more of all fee-generating activity for Wall Street. They are the biggest players positioned to harvest information across the entire capital market, and they use that information to time exits, entries and fundraising.
You argue in the book that index funds and private equity have practically become ‘political organisations.’ How did that happen?
The politics arises because of concentration. If the industry only consisted of many dispersed firms, like the mutual fund industry 30 years ago, I don’t think they would be significant political players. But the index funds have grown at the largest scale, especially the top three or four. So the problem is that 12 people largely control the outcomes of votes at shareholder meetings for public companies.
When Exxon had a proxy fight a few years ago, the dissident was able to elect directors to the board over the objection of Exxon. They had a very different political agenda, but they were able to do that because the index funds supported them. Currently there is a debate going on over labour policy at Starbucks and other companies. Again, index fund votes are largely determining how those struggles are playing out. So it is the concentration of voting power in a small number of funds that gives them enormous power through the shareholder control process, and with a different result than 20 years ago.
Private equity is different. Their power comes from controlling about 15–20 percent of the entire US economy. About eight or nine percent of US workers work for private equity, even if they don’t know it, because part of the structure of private equity is to make no disclosure. It is difficult to find out who owns what. But they make important choices about how the companies they operate are run, and they have political effects.
Currently in Boston there is a hospital chain that private equity bought out a few years ago. They took on financial risk, and it is probably going to go bankrupt in the next few weeks. That is going to shut down major hospitals in Boston, depriving people of basic healthcare. That is putting a spotlight on the role of private equity not just in that sector, but other parts of the economy too.
You also claim that private equity is not really private anymore. Why is that?
Private equity was originally private in the sense that most of the capital that early buyout funds were raising was from a few wealthy individuals. The SEC limited the number of investors, preventing funds from raising money from lots of institutions. They also had ‘look-through’ rules, which meant that if a fund raised money from other funds, it could be a problem. That changed in the 1990s. Now SEC reports show that their principal investors are institutional investors: pension funds, endowments, other funds. So the ultimate economic beneficiaries whose money is being managed are millions of people. A typical private equity fund is no longer managing money just for a few people, but for the public.
It is effectively the same type of capital formation process that goes into a public company, but through a different set of channels, which don’t trigger a requirement to register with the SEC. In fairness, they don’t list the shares of their portfolio companies. So in that sense they are still private, but the ultimate economics are more public.
Should they be regulated like public companies then?
I don’t think their structure lends itself to taking public companies’ disclosures and dropping them onto private equity. However, there is a public interest in how they are being run, what risks they are taking, and whether that generates returns that compensate investors. The reason is that US pension funds, especially public pension funds, face relatively light oversight. So if private equity is doing a large part of the investing for those pensions, ultimately US taxpayers are on the hook if the pension funds’ money is not well invested.
Private equity occasionally goes through periods when the risks they take don’t generate returns. When they buy a company, they borrow money and that debt creates financial risk. Some private equity funds generate other kinds of harm through the way they run the kinds of companies they increasingly own. Today, they are active in professional services, healthcare, service businesses regulated in ways that make some disclosure a good idea for the industry.
Control the outcomes of votes at shareholder meetings for public companies
I wish it was as simple as doing the same thing as with public companies, but I don’t think that would be a good model. Most of their operations are portfolio companies that don’t have the capacity to produce quarterly reports or engage with investors. It would be odd to require that kind of detailed reporting when the only exit would happen several years later. So a reporting regime is a good idea, but not the public company regime.
If this is a problem of market concentration, isn’t breaking them up the standard regulatory response?
If we are talking about an excessively concentrated product market or service market, antitrust or competition policy has often been the way we respond. But it is not the only way. Take early dominant players in sectors that at the time were high-tech, like electricity and water. Companies that provided what we now call utilities enjoyed massive concentration. We didn’t try to break those up. Sometimes we did, and sometimes there were limits on size.
Another path is to regulate them and allow them to provide benefits because they enjoy economies of scale. This is ultimately the problem. If you break up companies that enjoy efficiencies at great scale, and therefore concentration, you are imposing greater costs on the people who benefit from their services. It will be more costly for 12 index funds to function than four, so they won’t be able to do the same job at the same price.
Isn’t it worth paying that price?
Maybe, but another way to go would be to say: ‘okay, we don’t mind that they are so big and concentrated, but we don’t want them to use their power in ways other than their basic utility, which is to invest in a low-cost, diversified way.’ On the regulation side, they have already started to take the first step themselves by being more transparent about how they go about making voting decisions on behalf of other people. They now report quarterly, although they are only required to report annually. I don’t know why they can’t report in real time; the technology is available for that. I would encourage them to go even further.
A typical private equity fund is no longer managing money just for a few people, but for the public
More importantly, they have started, at least in principle, to give their investors the option to pick different policies for them to follow about how to vote. So far, the policies are very similar to each other. Over time for this to work, policies will have to become more varied. There is also a question of whether they will follow the instructions, but this is a work in progress.
The closest analogy is thinking of them as quasi-government agencies. We don’t want to have multiple central banks, that is a contradiction: two central banks are not better than one. What we want is more accountability and transparency.
Would you pin your hopes on a Biden or a Trump administration to address this issue?
Any government that doesn’t obey the law, I don’t have any faith in. I may not love the Biden administration all the time on every issue, but they follow the rules. With normal Republican and Democrat candidates, I might have a different view, but Trump has zero commitment to the rule of law. Once you say that, there’s nothing else to say.
