Two years ago, to the surprise of many, a small hedge fund focused on climate-impact investing managed to oust three ExxonMobil board members at the annual shareholder meeting and replace them with greener candidates, including a sustainability expert. Since the hedge fund owned only a tiny fraction of Exxon’s shares, how did it prevail?
By convincing the country’s three biggest index funds to support its candidates. These funds — BlackRock, Vanguard, and State Street — not only own an outcome-changing percentage of Exxon stock but are on track to own half the stock in all American companies within 15 years.
Over the past two decades, as this example shows, index funds — as well as private equity funds, another type of asset management company — have gained enormous influence in the economy and politics, according to John Coates, the John F. Cogan, Jr. Professor of Law and Economics at Harvard Law School, in his new book, “The Problem of Twelve: When a Few Financial Institutions Control Everything.” After the governance change at Exxon, he explains, the company began investing billions of dollars in carbon sequestration. “It was kind of a radical change” for the fossil fuel company, says Coates, an expert in corporate governance and a former general counsel to the Securities and Exchange Commission, and it “almost certainly would not have happened but for this intervention” by the index funds.
The term “problem of 12” describes a situation in which a handful of actors exert outsized influence on the politics and economy of a nation. “The main point,” says Coates, “is there’s a small number of people who ultimately are in charge of a small number of institutions, both in the index fund world and in the private equity world, that are coming to have an incredibly outsized and unprecedented amount of control over the economy, through the investments that they manage for other people.”
Through most of the 20th century, publicly traded companies and major financial institutions dominated the U.S. economy, and that presented a similar kind of problem of 12 — economic and political dominance, lack of transparency — which resulted in significant reforms, including the creation of the SEC. But that old corporate governance system is dying, according to Coates. Today, private equity funds and index funds are growing in size and power incredibly fast, and that raises for Coates two perhaps paradoxical concerns.
One is how they are influencing American democracy. “Their growing concentrated wealth and power threaten the foundations of a democratic republic built on Montesquieu’s separation of powers as well as federalism,” Coates writes. His other concern? As these funds come under increased scrutiny from the public and policymakers, ill-considered reforms may lead to unintended consequences that throw out the good with the bad.
A few years ago, Coates says, “I started seeing these proposals that were just terrible ideas that were being taken very seriously by senior elected officials,” and that prompted him to write the book. “Because index funds certainly, and private equity funds possibly, create value within the U.S. economy,” he writes, “the threats to them are as important as their potential threats to American democracy.”
His book is more about raising questions than providing a set of specific solutions, Coates emphasizes, and as such is garnering widespread praise as a thoughtful approach to analyzing these financial behemoths. Former SEC Acting Chair and Commissioner Allison Herren Lee calls it a “must-read for policymakers and policy influencers on both sides of the aisle.” Larry Summers, former president of Harvard University, a professor at the Harvard Kennedy School, and a top economic official in both the Clinton and Obama administrations, says Coates “makes a compelling case that American capitalism part way into the 21st century is dominated by a dozen insufficiently accountable institutions,” adding that the book “deserves the attention of all who care about our economic future.”
‘A brilliant, deceptive rebranding’
While index funds and private equity funds each have been around since the 1970s, it was only around 2000 that they both began a meteoric rise, in the case of private equity funds due in large part to a rebranding effort. Private equity funds, according to Coates, are basically leveraged buyout (or LBO) organizations. They borrow huge amounts to purchase entire companies, then cut costs — often by laying off workers — and resell at a profit. In the 1980s, widespread bankruptcies and massive layoffs spurred by LBOs, and famously spotlighted in the movie “Wall Street,” created a serious PR problem, so they were reborn under a new name.
It’s the “brilliant, deceptive rebranding of buyout funds as ‘private equity funds,’” Coates says, noting that there’s nothing truly private about them except that they operate in near-complete secrecy. “Businesses owned by the private equity industry no more deserve the connotation of ‘private’ than General Motors or Exxon does,” he adds.
And they’ve grown “at a bigger scale than anybody would have dreamed possible in 1990,” he says. Between 2000 and 2021, private equity funds grew from $770 billion of global assets under management to $12.1 trillion, or “four to five times faster than the U.S. economy as a whole,” Coates writes. The Big Four private equity firms — Apollo, Blackstone, Carlyle, and KKR — have together amassed $2.7 trillion of assets. “They are now by far the biggest growth sector in how companies are owned,” he explains.
And, importantly, he says, there is almost no oversight, even though the private equity business is risky. There are many funds within a private equity firm, and because technically each fund is its own separate entity, it counts as only a single shareholder and thus is outside the scope of the SEC. But, Coates notes, “that one shareholder is raising money from millions of people” — some of the biggest investors in private equity funds are public pension funds. Moreover, one in every eight or nine workers in the U.S. now works for a private equity company, “whether they know it or not,” he says.
“They’re putting lots of people’s savings and jobs at risk in ways that I don’t think are appreciated because there’s no disclosure,” Coates says. “And the people they’re investing for — the pensioners whose money is being invested by a pension fund in a private equity fund in a buyout — I’m quite sure they have no idea that that’s how their money is being used: for a buyout.”
As private equity grows and draws the veil of secrecy over more of the economy, the industry resists calls for increased transparency — and exerts political clout to protect itself, he notes. Private equity was a major force behind derailing the attempt to close the carried interest loophole, which allows investment managers such as those managing private equity firms to treat their earnings as capital gains instead of income, so they pay a lower tax rate.
‘Never the goal of the index fund creators’
By contrast, index funds are regulated by the SEC; secrecy isn’t the problem, size is. Index funds are a type of mutual fund but are not actively managed, so their fees are low, and they offer many benefits to the average investor. And the not-so-average, too. In 2015, basketball superstar LeBron James asked billionaire Warren Buffett for advice on investing the $300 million he’d earned so far in his sports career. Buffett suggested he put money each month into a low-cost index fund. Within seven years, James had tripled his assets, and today he, too, is a billionaire.
“I’m a big fan” of index funds, says Coates. “As an investment vehicle, they’re the cheapest, safest way for a typical American to invest in the stock market.”
But an index fund is rewarded by economies of scale. “The bigger it is, the better it can do what it does, which is to buy all the companies available in an index, which often is the entire stock market or something close to it,” Coates says. Unlike the old model of corporate governance, where no single investor was dominant in a company, “the big index funds now own already 25% of all the stock of all the companies on all the stock exchanges — which is just an astonishing shift from 25 years ago. They’re on a path to continuing to grow and probably will own more than half of all the stock — effectively totally controlling, if they wanted to, all of those companies over the next 10 to 15 years.”
As the Exxon example demonstrates, “Today there are roughly a dozen index fund managers who collectively have enough corporate power to determine the fate of most public companies,” he says. “Index funds have become increasingly politically influential on issues such as diversity, treatment of workers, and climate change,” drawing criticism — depending on what they decide to do on these issues — from both the left and the right.
“The reason I wrote the book is I think [index funds] are great and I don’t want them to get crushed by politics,” he says. “It was never the goal of the index fund creators to generate this much concentrated ownership. But the fact that they’re getting that concentrated ownership ends up being potentially a threat to them.”
Coates has been on a book tour in Houston, Philadelphia, Washington, D.C., New York, and Boston, and he’s found that people in these audiences, no matter their political affiliation, are skeptical, even suspicious, of the power these funds have. While he doesn’t offer any magic bullet answers, more transparency and soliciting more input from their own investors would go a long way, he advises.
“Both industries are going to get increasingly buffeted by political proposals to restrict, regulate, and change the limits, possibly making their business model ineffective,” he says. “I’d like to think that the book will help to contribute to a more sustained and engaged debate about what to do [and] help contribute to people thinking hard now about better solutions, rather than worse ones.”