‘Most Americans are not aware of how concentrated the financial sector has gotten,’ Harvard Law professor says

Play Video duration:31:20

Each semester at Harvard Business School, the school’s Institute for Business in Global Society (BiGS) invites scholars and practitioners to campus to share with faculty their ideas about the role of business in addressing societal problems. The BiGS Fix is here to share their insights. Today’s piece highlights our conversation with John Coates, a professor of law and economics at Harvard Law School and former general counsel of the U.S. Securities and Exchange Commission, to discuss insights from his new book, “The Problem of 12: When a Few Financial Institutions Control Everything.” The transcript has been edited for length, clarity, and style.

In your book, you argue that concentrated ownership of private equity firms and index funds raises serious questions for business and society. What are those questions?

Index funds and private equity funds enjoy enormous economies of scale. The bigger they get, the better they are at doing the basic financial functions they were set up to do. A small number of these players are controlling larger and larger amounts of the U.S. economy, which means a small number of people have greater control over the U.S. economy and society. The power of index funds was demonstrated when they helped dislodge members of the board of Exxon in a proxy fight.

Give us a brief explanation of the history of private equity and how it is evolving

Private equity has its origins in leveraged buyouts in the 1970s and 1980s. The idea was to take companies, usually publicly listed on the stock exchange, borrow a lot of money—that’s the leverage—and buy them out. Then, they could use their control to improve the value of the company and resell it, typically 3 to 5 years later. That’s the original idea of what private equity mostly does.

What’s changed since then is that the scale of operations of private equity has grown and grown and grown—to the point that now private equity controls between 15% and 20% of the entire U.S. economy. They’re no longer buying isolated companies and flipping them back to the public markets. Instead, they buy them and sell them to mostly other private equity firms. They’ve become their own separate capital universe.

You mentioned 15% to 20% of the economy is private equity. Does that surprise you?

Yes. Private equity has been growing at a compound annual growth rate that vastly exceeds that of the economy. It uses different kinds of investments, such as credit and real estate funds, and investments in commodity markets.

You mentioned that the term ‘private equity’ is misleading. Can you explain?

‘Private equity’ as a phrase sounds like some wealthy individual who owns companies. Most of the investors in private equity funds are themselves institutions, not individuals.

The biggest category of investors is pension funds which are investing on behalf of thousands or millions of workers or retirees. So, the money that private equity firms, invest and use to run companies is derived from the public in a broad sense in the same way that a public company listed on the stock exchange has raised its capital from the public. So, ‘private equity,’ while a nice phrase to connote certain aspects of how private equity functions, really is misleading. It’s really investing on behalf of the broader public.

What sort of problem will this pose for business and society?

The private equity industry is very good at convincing Congress or regulatory officials to shape laws in a way that allows them to remain essentially dark. They don't put out public reports. They don't put out any information that the public can use to evaluate what they're doing, or even their investment performance.

It is increasingly a challenge for the legitimacy of capitalism. Capitalism depends upon some degree of transparency about how it's functioning, how workers are being treated, and how consumers are being treated.

How does that impact society?

Over the past 20 years, private equity has moved increasingly into new sectors, many of them in service businesses. These include medical businesses, dental offices, and pet care facilities. There's no way to observe what they're doing on a routine basis.

Medical care is an example. We regulate it by relying on a series of norms that doctors won't harm their patients, even if it might make them more money. Now, if you take a private equity firm with debt, maybe they'll skimp on care, understaff the nurses, or engage in overdiagnosis. It might help short-term profit, but not be a good result for people in general.

Can you give us a brief explanation of the history and concept of index funds?

Financial economists in the 1960s theorized about how hard it was to identify investments that would outperform the market as a whole and that maybe we would be better off not trying. Instead, they suggested buying all the stocks you could buy. Vanguard was founded on this idea.

It works because you're saving a lot of money on the investment professionals that you're not having to hire. It still provides a good return and you're diversified because you're buying all the companies in an index, which tends to reduce risk. It tends to beat most active management organizations. Index funds have become increasingly dominant.

What role do index funds like Vanguard, BlackRock, and State Street play in the economy?

Index funds, since the year 2000, have grown their assets at a rate that's vastly greater than the growth of the economy or stock markets. The top four index funds currently own 20% to 25% of the stock of every company on the stock exchange. With that ownership comes voting power, the ability to determine often who's on the board of a company, or how shareholder votes on various issues will come out.

What are the risks of this growth?

Index funds are correctly viewed as playing an important role in politics and in governance which makes them subject to attacks by politicians and people skeptical of the choices they're making. To keep doing what they do well, investing for millions of middle-class Americans, they need to be regulated more than maybe they would like. More disclosure about how they use the power they have would be a good first step.

Can you explain how the private equity industry differs from index funds when it comes to disclosure?

Index funds are currently subject to disclosure requirements, and that's how I can tell you what percentage of the companies they own. Private equity firms, by contrast, never have to make public disclosures. Private equity disclosure would be a dramatic change. Many of them would resist. The more thoughtful would recognize there's some value in greater transparency. Some disclosure would be good for the industry itself. They could tell better stories about themselves.

Why is the absence of disclosure for private equity firms a problem for society?

If pensions don't generate adequate returns, it's usually taxpayers who are on the hook for the deficit, particularly for public pensions. Since a large part of the money that pensions now invest is invested through private equity, the public has an interest in understanding the risks and the returns that private equity is generating for pensions.

In today's world, stakeholders are increasingly calling on companies to conduct business in ways that are better for people and the climate. Do you think tighter disclosure rules could help get businesses to change?

This is an important dimension of what disclosure can do. For example, water shortages and other environmental problems are often directly attributable to business activity. Disclosures about company impact can be just as important to the public as their investment returns. Most other countries do have some disclosure, even for private-equity-owned businesses if they're big enough. The U.S. is relatively unusual in having none.