Index funds and private equity funds enjoy enormous economies of scale. From a pure financial perspective, that may be fine, but one consequence of the scale at which they're currently operating is concentration. And I think most Americans still are not really aware of how concentrated the financial sector has gotten.
Private equity controls somewhere between 15 and 20 percent of the entire U.S. economy, and they're no longer buying isolated companies and flipping them. Instead, They buy them and then they sell them to mostly other private equity firms. They've become their own separate capital universe.
The top four index funds currently own 20 to 25, sometimes as much as 30 percent of all of the stock of every company on the stock exchange. The challenge is how will the index funds use their power to push companies to be more or less responsible about the social impacts they have. And that can be very controversial.
My name is John Coates. I'm a professor of law and economics at Harvard Law School. In finance, there have been many episodes where financial institutions have gotten very large. And I think we're living through another one of those episodes. 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. And from a pure financial perspective, that may be fine. But one consequence of the scale at which they're currently operating is concentration.
Small number of these players are controlling larger and larger. amounts of the U.S. economy, which means a small number of people are having greater and greater control over U.S. economy and society more broadly, the political system. And they're very important now in a way they were not 20, 25 years ago. And so, no, I don't think most Americans appreciate it because it's one of those problems that's just sort of emerged year after year.
It's gotten more and more important and more and more serious. And it really only hit, I think, a tipping point of attention just a couple of years ago when index funds, for example, were able to help dislodge members of the board of Exxon in response to a proxy fight. That was a surprising event. It got a lot of news. It was a symptom of the changes that I cover in the book.
But it's only one episode. And I think most Americans still are. not really aware of how concentrated the financial sector has gotten. Private equity has its origins in leverage buyouts of the 70s and 80s.
The idea back then was to take companies that were usually publicly listed on the stock exchange and borrow a lot of money, that's the leverage, and buy them out, that's the buyout. And then because the ownership of a private equity firm tends to be quite concentrated, the people running it, small in number, they could use their control to improve the value of the company and then resell it, typically three to five years later. So 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 now that private equity controls somewhere between 15% and 20% of the entire US economy. And they're no longer buying isolated companies and flipping them back to the public markets. Instead, they buy them and then they sell them to mostly other private equity firms. They've become their own separate capital universe.
So you start with basic transactional idea, and it's turned into an entire sector of the US economy. Private equity as a phrase sounds a lot like some wealthy individuals who own companies. That's, I think, the kind of standard take of what that kind of enterprise is. In fact, most of the investors in private equity funds are themselves institutions, not individuals.
And the biggest category of investors are pension funds, who are obviously investing on behalf of. Typically thousands or millions of workers or retirees. So the money that private equity forms and invests and uses to run companies really 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 a little misleading. the sense that it's really investing on behalf of the broader public.
Well, as a first-pass matter, if pensions... don't generate adequate returns and fall short of their ability to meet their pension obligations, it's usually taxpayers who are on the hook for the deficit, particularly for public pensions, teachers, for example. So the public as a whole, the taxpayers as a whole, have an interest in making sure that pensions are investing well and since a large part of the money that pensions now invest is invested through private equity.
That means the public has an interest in understanding the risks and the returns that private equity is generating for pensions. And currently, that is not a matter of public record. If you're a taxpayer and you're interested in understanding how the public teacher's pension fund in Oregon is investing, you might get some very general reports out of the body that oversees that pension fund. But you're not going to get detailed information about the companies that the private equity funds.
that that pension fund is investing in are owning and operating. You're not going to be able to tell whether they're taking significant financial risks or not, and you certainly can't tell whether the returns that are being generated are appropriate to match the risk that the fund is taking. It's a basic question of accountability and making sure that the public's money is being invested well. Right now, there's very limited visibility into how that's being done.
I've been tracking private equity since I was a young lawyer back in the 80s. I was aware of its role in the merger and acquisition markets, but I had not really focused just on how dramatically the largest private equity firms have grown over the past 20 years. Since roughly 2000, private equity has been growing at a compound annual growth rate that vastly exceeds that of the economy. So it's beginning to take over more and more of the economy using all kinds of different kinds of investments. Not just leveraged buyouts, but credit funds and real estate funds and investments in commodity markets.
And so private equity has become just much bigger than I think is commonly appreciated as a part of the U.S. economy. The private equity industry has been very successful in lobbying. They're very good at...
convincing Congress or regulatory officials to shape law in a way that allows them to remain essentially dark. That is, they don't make disclosure. They're not in the public domain. They don't put out public reports.
They don't have any kind of information that the public can use to evaluate what they're doing. Even the investments performance is not a matter of public consumption. So when one out of every 10 or 15 workers in the entire economy is employed by a type of fund which raises money from the public, but which makes no disclosure to that public about how they're using their money, that I think is increasingly a challenge for the legitimacy of capitalism. I think capitalism depends upon some degree of transparency about how it's functioning, not simply the bottom line of whether unemployment is at a given level or not, but how employment functions and how workers are being treated and how consumers are being treated.
All of that in turn depends on disclosure, and private equity is still not engaging in a significant disclosure about its operations. One of the underappreciated aspects of private equity over the last 20 years has been that it's spread from the conventional kind of company private equity bought typically was a manufacturer doing something relatively straightforward, and the goal there was to streamline operations, cut costs. Over the past 20 years, private equity has moved increasingly into new sectors, many of them in the service businesses, and many of them in service businesses where we have a hard time regulating or governing the conduct of business. I mean, that sounds a little vague.
Medical businesses, dental offices, pet care facilities, these are all areas where private equity has dramatically grown their presence and bought up more and more businesses. Now, what's the social issue there? Well, remember, there's no disclosure. So when private equity buys these kinds of businesses, there's no way to observe what they're doing on a routine basis.
And these kinds of businesses typically involve services that are hard to evaluate. and hard to regulate. We regulate medical care delivery in part by relying on doctors to be socialized through medical school into a series of norms that they won't harm their patients, even if it might make them more money to do so, that they will disclose adequately to their patients what they're about to do, etc.
We don't have all of those norms written down into laws that can be enforced. very easily. We rely on the doctor's own self-restraint.
Now you take a private equity firm with the debt they raised the money to buy the firm with, which requires repayment, and very sharply powered incentives to maximize short-run cash flow, and you layer that on top of medical professionals, and I think that dramatically affects the way that a medical facility is likely to function. Maybe they'll cut costs in the same way they would with a manufacturing company, and that might be good. But maybe they'll also skimp on care or understaff nurses or engage in over-diagnosis of problems in ways that might help the short-run profit of the firm, but not necessarily be a good long-run result for people in general.
And so just to reiterate, this only is a relatively recent phenomenon. If you go back 30 years, private equity was not. in the medical business. It is increasingly in the medical business.
It's in the dental business, it's in the pet care business, it's in the burial services business. These sectors are ones where I think society's interests are a little different than in a standard manufacturing company. Index funds were, I'm proud to say as an academic, a creature of the academy.
Financial economists in the 60s theorized about how hard it was to identify investments that would outperform the market as a whole and theorize that maybe we would be better off not trying to do that. Instead, just buy all the companies or buy all the stocks that you could buy. And Vanguard was founded on this idea in the early 70s. It took a long time for Vanguard to convince anyone that Indexing, that's this idea of buying all the companies in an index, was a sensible thing.
It sort of seems a little counterintuitive. Turn your money over to someone who won't think about what to buy. Instead, we'll just go to a list that anybody could look up and buy all the companies in that list.
How does that work? Well, it works because you're saving a lot of money on the investment professionals that you're not having to hire. And because the market overall tends to outperform. Over time, say borrowing, it still provides you a good return and you're diversified because you're buying all the companies in an index, which tends to reduce risk.
So that package turns out to be a good one. It tends to beat most active management organizations over time. And as a result, index funds have become increasingly dominant in the investments in public companies. Like private equity funds, index funds since the year 2000 have... grown their assets at a rate that's vastly greater than that of the growth in the economy or the growth in stock markets as a whole.
So from around 2% of total equity of most companies back in the 90s, the top four index funds currently own 20 to 25, sometimes as much as 30% of all of the stock of every company on the stock exchange. Let me just say that again. Four firms, 30% of the stock of every company, which is listed on a stock exchange.
And that's a dramatic growth story, one that I think is, again, underappreciated by most Americans. And 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. The fundamental drivers of the success of index funds don't seem to be going away. So the bigger they get, the better they are.
The better they are, the bigger they get. There's a kind of virtuous circle that feeds their growth. And that's why I think unless something happens politically, they're going to grow to the point that the top three or four are going to own more than half of all the stock in every listed company on the stock exchange.
And when that happens, they will be able to, at least, determine who's on the board. of those companies. Putting aside family-owned companies like Walmart, for companies that don't have a dominant single shareholder, it will be the index funds that can determine who's in charge of the company.
So the significance for the country is suddenly the people running the index funds in some ways are more important, at least as a practical governance matter, than the composition of the boards of all those companies. They were never created to play the role in governance that they're currently playing. And yet because they have this concentrated ownership and power that comes with it, they are correctly viewed as playing a very important role in politics and in governance that makes them subject to attacks by politicians and people very skeptical of the choices they're making. So in some sense, the problem they create is that in order to keep doing what they do well, they need to be regulated more than maybe they would otherwise like to be.
The trick is to find ways to regulate them, to limit their power without destroying their ability to do their basic financial task. And so that I think is still a work in progress. I don't have a magic solution to it, but I do think more disclosure by index funds about how they use the power they have would be a good first step.
Personally, I think that index funds create some good effects. The concentration of power they have means that there's a small number of people who are really paying attention at various moments in the operation of a company. So I'm not sure that it's important to reduce their influence so much as to improve understanding and increase transparency about how they're using that power.
Currently, they do report votes. They report it more frequently than they have to, actually. They report quarterly instead of annually, which is the requirement.
I think they could go to an even faster pick cadence. I don't know why they can't just report votes on a running basis. It's simple in the current technology that we have. But more importantly than that, I think, is to also have some disclosure and even interaction with their own investors before they get to a vote.
If they know there's a new issue that's going to be coming up in the annual voting cycle for companies they own, I would like them to let the world know that. and say they're thinking about it, and here's how they're thinking about it, and here's who they're meeting with to form views. Because that process often has to occur before the vote, and by the time you get to the vote, they largely have already made up their mind about what to do. So knowing how they vote, while useful in evaluating them over time, is not very helpful if you have a view or an interest or a... some knowledge that actually might be useful for the index funds to take into account in reaching their own decisions.
So my preferred solutions in how they should be functioning involve greater transparency over time, not simply about a particular vote, but about how they are thinking about the kinds of issues where they do and don't intervene at companies that they own. So index funds are currently subject to disclosure requirements. And that's how I can tell you what percentage of the companies they own. And I can even say something about how they vote.
Private equity firms, by contrast, stay out of the disclosure regime. They're designed to, under the rules that Congress has passed over time, never have to make public disclosures either about what they own or how they're being run or any aspect of the risk and returns. that they're generating for their own investors over time.
So they're very different that way. Index funds already have disclosure. I think more could be done with index funds to make them more transparent as to how they're using their power. But at least we're starting with a base of existing disclosure requirements.
Private equity, on the other hand, this would be a fairly dramatic change to start to require disclosure from them. I think many of them will resist if this was proposed, as has been the case. I think the more thoughtful private equity firm managers recognize there's some value in greater transparency.
And so I think in the end, there may well be workable disclosure that could be developed for private equity. But again, it'll be starting from basically nothing. A traditional investor-oriented disclosure idea is about risk and return, and I think that's very important.
But the broader public also has an interest in how the economy is functioning because it has direct effects on the climate, for example, on the environment more generally. Water shortages and the like are often directly attributable to business activity. So disclosures that are about the impacts of companies can be just as important to the public as their investment returns.
And so, again, because private equity is completely in the dark, we have very limited visibility into the impacts that that overall financial sector is having on the world, on the public and the people that are part of the democracy in which those private equity firms are functioning. Index funds are a little different because they typically own public companies and those public companies are making disclosures. But here, the challenge is how will the index funds use their power to push companies to be more or less responsible?
about the social impacts they have. And that can be very controversial. Some people think that, for example, climate change is a near term and serious risk to the survival of the planet. And for that reason, they want the index funds to be pushing companies to be more responsible about the energy they consume. Other people are more skeptical about that.
In any event, the power they have has to be used one way or the other. They have it. And now that means that the focus of struggle over how businesses are operating on the public company side has been moved to index funds. What the index funds are doing will impact the way in which Exxon, for example, is having an effect on the world.
Private equity It has several different aspects to the way it owns and manages companies. One aspect is it typically borrows money. The debt that's used to buy out a company with private equity ownership creates a sort of discipline because you have to pay debt.
You can't choose whether you're going to pay a dividend or not. You have to be in interest rate payments. That creates a sense of urgency and commitment.
to doing a better job with the company's assets. And so that's a way in which private equity structure can be helpful to the operation of many, many companies. On the other hand, another aspect of private equity is that it's set up and designed to avoid disclosure requirements altogether.
And I'm not so sure that that's essential to the way that the rest of private equity adds value to the economy. At a minimum, after the fact disclosure, of how the private equity firms have run companies and the risks that they've taken and the returns they've generated would seem to me to be consistent with the private equity model might actually help them achieve a greater degree of legitimacy in the eyes of the public. I don't think the industry is reflexively going to embrace disclosure because I think it's long gotten used to the idea that operating in the dark is a useful thing.
And in some ways it can be. It means there's less close attention to daily decisions that can sometimes be problematic. But I do think there are ways to write disclosure rules that the private equity industry could live with and in fact already has to live with in other countries.
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. Disclosure practices are partly voluntary in response to market demand and they're partly mandatory in response to legal requirements.
Usually there's a market demand first before a regulator will get to the point of requiring something and in fact most companies above a certain size today already for example make disclosures about their climate impacts. The SEC is currently Considering proposed rules to mandate those for all companies that are listed, their efforts to get privately held companies also to engage in disclosures. And it's interesting, actually, the private equity industry does put out some sustainability reports on a voluntary basis already about itself, more than they do about their own financial operations, interestingly. The question of how far government will go into this space is a political question.
And it depends heavily on the politics and governance of a country. Europe is already there. They mandate disclosures about climate impacts, even for U.S. companies, if they're big enough and have enough operations in Europe, as many American multinationals do. So, in effect, U.S. companies, businesses, are already having to adhere to some mandates because Europe was farther along and earlier in getting that done.
The SEC's pending rule is almost certainly going to be adopted, in my opinion. It probably won't be as quite as expansive as the European rules. California has adopted its own rules for companies that are active in California, which then affects another chunk of US operations.
That set of rules is being challenged in court, so we'll see if it's sustained. But what I think is most interesting about all of the regulatory interventions in the climate space is even if you got rid of them all, most companies are already making disclosures about their climate impacts because investors are demanding it. And so I think the right way to think about the regulatory involvement here in disclosure for public companies, for index funds, and increasingly possibly for private equity, is can you make the disclosures more reliable, more consistent, and more useful over time? I think that's the most important thing regulation can do of disclosure.
Famously, Louis Brandeis said the best disinfectant is sunlight and the best policeman is an electric light on the street. And while it's not really true that sunlight is the best disinfectant, there is some truth to what he used to say. And that's sort of been a mantra for the disclosure regimes around the world for the last hundred years. The idea is that by forcing companies to explain and provide information about their activities, that the Personal interests of the people running the company are less likely to distort how the company is being operated.
It improves governance to report on compensation in a detailed way because shareholders will be able to see the linkages between what companies are doing and how the executives are being paid. And even if they might disagree with a particular choice, knowing they're going to have to disclose what they're doing means that the pay packages are designed with investors in mind. So disclosure is a crucial element, I think, of effective corporate governance for any large company. The average American occasionally hears about private equity in mostly negative ways. They read headlines about problems.
They read headlines about bankruptcies. Because private equity increases debt, it can increase financial risk. That can lead to bankruptcy. So I think average Americans, to the extent they're paying attention at all to the financial sector, are mostly hearing negative stories about private equity. And that's why I think actually some disclosure by the industry would be good for the industry itself.
They could tell some better stories about themselves if they had a better disclosure regime. Index funds, again, for the portion of the American population who invests, they have become increasingly known. It is increasingly the way in which most people choose to invest.
I don't think, however, most Americans understand just how much. Governance power index funds have unless they live in a red state like Texas where it's become a political talking point that BlackRock has been a problem according to the Republican governor of that state. So if Americans are aware of index funds it's either as investment vehicle or sometimes in the political sphere.
That is part of the point of the book. It's becoming increasingly a political problem for index funds. that they're as big as they are. So the idea that private equity would adapt the traditional way it invests to incorporate more ownership by employees, by a broader number of people, in effect to share the wealth of the gains of the way private equity functions, is an interesting idea.
It's newish. It's not really been Part of the standard private equity toolkit, it is interesting that KKR is publicly embracing this as a part of their overall strategy. I actually think it's a reflection of the focus of the book, which is that private equity leaders that are more thoughtful understand the public is a little skeptical about what they do and that this effort to broaden ownership within private equity-owned firms is partly responsive to worries that they're... making inequalities of wealth greater over time.
Whether it's in the end enough or the right answer to all of the challenges that private equity creates, I'm not so sure. I think there's some businesses where the scale of the business is such that it's just unlikely that the employee base will be able to own more than a small fraction of the equity of the company. But in the professional services end of what private equity does, it does seem like a promising path.
Analyst calls have already begun over the last 10 years to include more questions about topics that generically fall under the umbrella of sustainability. And I think that's a growing recognition that investment returns over time depend upon strategies and operations that are in fact sustainable. And it's a discrete risk dimension that maybe was neglected in the past. So I think it's already happening and I think it will continue to happen. I think it's hard to imagine a world in which companies that depend heavily on energy inputs are not going to continue to have to think hard about the source of their energy.
Companies that have physical plant located in floodplains are going to have real risks that storms may interrupt their operations. So it would be reasonable and I think totally predictable and sensible for analysts and journalists. who cover business to be asking questions about those aspects of how companies are operating.
Just to be clear, I don't really think this is a truly new thing, but I do think it has become a more regular part of investment interaction.