Transcription
Index funds and private equity funds benefit from significant economies of scale from a purely financial perspective. While that may seem fine, one consequence of their current scale is concentration. I think most Americans are still not really aware of how concentrated the financial sector has become. Private equity controls between 15 and 20% of the entire U.S. economy. They are no longer just buying isolated companies and flipping them; instead, they buy them and then sell them to mostly other private equity firms. They have become their own separate capital universe.
The top four index funds currently own 20 to 25, sometimes as much as 30%, of all the stock of every company on the stock exchange. The challenge is how these index funds will use their power to push companies to be more or less responsible regarding their social impacts, which can be very controversial.
[Music]
My name is John Coates. I'm a professor of law and economics at Harvard Law School. In finance, there have been many instances where financial institutions have grown very large, and I think we are 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 performing the basic financial functions they were set up to do. From a purely financial perspective, that may be fine, but one consequence of their current scale is concentration. A 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 control over the U.S. economy and society more broadly, including the political system. They are very important now in a way they were not 20 or 25 years ago.
I don't think most Americans appreciate this because it's one of those problems that has emerged year after year, becoming more important and serious. It really only hit a tipping point of attention a couple of years ago when index funds, for example, helped dislodge members of the board of Exxon in response to a proxy fight. That was a surprising event that received a lot of news coverage. It was a symptom of the changes I discuss in my book, but it's only one episode. I think most Americans are still not really aware of how concentrated the financial sector has become.
[Music]
Private equity has its origins in leveraged buyouts of the 70s and 80s. The idea back then was to take companies that were usually publicly listed on the stock exchange, borrow a lot of money—that's the leverage—and buy them out. Because the ownership of a private equity firm tends to be quite concentrated, the people running it are 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. That's the original idea of what private equity mostly does.
What's changed since then is that the scale of private equity operations has grown to the point where it now controls between 15 and 20% of the entire U.S. economy. They are no longer buying isolated companies and flipping them back to the public markets. Instead, they buy them and then sell them to mostly other private equity firms. They have become their own separate capital universe.
So, you start with a basic transactional idea, and it has turned into an entire sector of the U.S. economy. The phrase "private equity" sounds a lot like wealthy individuals owning companies, which is the standard take on what that kind of enterprise is. In fact, most of the investors in private equity funds are institutions, not individuals. The biggest category of investors is pension funds, which invest on behalf of typically thousands or millions of workers or retirees.
The money that private equity firms invest and use to run companies is derived from the public in a broad sense, just as a public company listed on the stock exchange raises its capital from the public. So, while "private equity" is a nice phrase that connotes certain aspects of how it functions, it is a bit misleading in the sense that it is really investing on behalf of the broader public.
[Music]
As a first 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, like those for teachers. The public, as a whole, has an interest in ensuring that pensions are investing well. Since a large part of the money that pensions now invest is through private equity, the public has an interest in understanding the risks and returns that private equity is generating for pensions. Currently, that is not a matter of public record.
If you're a taxpayer interested in understanding how the public teachers' pension fund in Oregon is investing, you might get some very general reports from the body that oversees that pension fund. However, you won't receive detailed information about the companies that the private equity fund is investing in, nor will you be able to tell whether they are taking significant financial risks. You certainly can't determine whether the returns being generated are appropriate to match the risks that the fund is taking. It's a basic question of accountability and ensuring that the public's money is being invested well. Right now, there is very limited visibility into how that's being done.
[Music]
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 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. It is beginning to take over more and more of the economy, using all kinds of different investments—not just leveraged buyouts, but credit funds, real estate funds, and investments in commodity markets. Private equity has become 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 are very good at convincing Congress or regulatory officials to shape laws in a way that allows them to remain essentially dark. They don't make disclosures; they are not in the public domain. They don't put out public reports, and there is no information that the public can use to evaluate what they are doing. Even the investment performance is not a matter of public consumption.
When one out of every 10 or 15 workers in the entire economy is employed by a type of fund that raises money from the public but makes no disclosure to that public about how they are using their money, I think that increasingly challenges the legitimacy of capitalism. Capitalism depends upon some degree of transparency about how it functions—not simply the bottom line of whether unemployment is at a given level, but how employment functions, how workers are treated, and how consumers are treated. All of that depends on disclosure, and private equity is still not engaging in significant disclosure about its operations.
One of the underappreciated aspects of private equity over the last 20 years has been its spread from the conventional kind of company. Private equity typically bought manufacturers doing something relatively straightforward, with the goal of streamlining operations and cutting costs. Over the past 20 years, private equity has increasingly moved into new sectors, 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 increased its presence and bought up more and more businesses. Now, what's the social issue there? Remember, there's no disclosure. When private equity buys these kinds of businesses, there's no way to observe what they're doing on a routine basis. 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, and that they will adequately disclose 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 easily. We rely on the doctors' own self-restraint.
Now, you take a private equity firm with the debt they raise to buy a firm, which requires repayment, and very sharply powered incentives to maximize short-run cash flow, and you layer that on top of medical professionals. I think that dramatically affects how a medical facility is likely to function. Maybe they'll cut costs in the same way they would with a manufacturing company, which might be good. But maybe they'll also skip on care, under-staff nurses, or engage in over-diagnosis of problems—ways that might help the short-run profit of the firm but not necessarily be good long-term results for people in general.
To reiterate, this 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, the dental business, the pet care business, and the burial services business. These sectors are ones where I think society's interests are a little different than in a standard manufacturing company.
[Music]
Index funds were, I'm proud to say, 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. They theorized that maybe we would be better off not trying to do that. Instead, they suggested just buying all the companies or all the stocks that you could buy. Vanguard was founded on this idea in the early 70s.
It took a long time for Vanguard to convince anyone that indexing—this idea of buying all the companies in an index—was a sensible thing. It seems a little counterintuitive to turn your money over to someone who won't think about what to buy but will just go to a list that anyone could look up and buy all the companies on that list. How does that work?
Well, it works because you're saving a lot of money on the investment professionals that you don't have to hire, and because the market overall tends to outperform over time. So, 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. That package turns out to be a good one; it tends to beat most active management organizations over time.
As a result, index funds have become increasingly dominant in investments in public companies. Like private equity funds, index funds have grown their assets at a rate vastly greater than the growth in the economy or the growth in stock markets as a whole since the year 2000. 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 the stock of every company on the stock exchange.
Let’s say that again: four firms own 30% of the stock of every company listed on a stock exchange. That’s a dramatic growth story, one that I think is again underappreciated by most Americans. With that ownership comes voting power—the ability to determine who is often on the board of a company or how shareholders vote on various issues.
[Music]
The fundamental drivers of the success of index funds don't seem to be going away. 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. That's why I think unless something happens politically, they are going to grow to the point where the top three or four will own more than half of all the stock in every listed company on the stock exchange.
When that happens, they will be able to determine who is 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 is in charge of the company.
The significance for the country is that suddenly the people running the index funds are, in some ways, 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 are currently playing. Yet, because they have this concentrated ownership and the power that comes with it, they are correctly viewed as playing a very important role in politics and governance.
This makes them subject to attacks by politicians and people who are skeptical of the choices they are making. 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 they might otherwise like to be. The trick is to find ways to regulate them to limit their power without destroying their ability to perform their basic financial tasks.
I think this 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.
[Music]
Personally, I think that index funds create some good effects. The concentration of power they have means that a small number of people 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 as much as it is to improve understanding and increase transparency about how they are using that power.
Currently, they do report votes; they report them more frequently than they have to. In fact, they report quarterly instead of annually, which is the requirement. I think they could go to an even faster cadence. I don't know why they can't just report votes on a running basis. It’s simple with the current technology we have.
More importantly, I think there should also be some disclosure and even interaction with their own investors before they get to a vote. If they know there's a new issue coming up in the annual voting cycle for companies they own, I would like them to let the world know that and say they are thinking about it, how they are thinking about it, and who they are meeting with to form views.
That process often has to occur before the vote, and by the time you get to the vote, they have largely already made up their minds 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 some knowledge that might be useful for the index funds to take into account in reaching their own decisions.
My preferred solutions for 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.
[Music]
Index funds are currently subject to disclosure requirements, which is how I can tell you what percentage of the companies they own and even say something about how they vote. Private equity firms, by contrast, stay out of the disclosure regime. Under the rules that Congress has passed over time, they never have to make public disclosures about what they own, how they are being run, or any aspect of the risks and returns they are generating for their own investors over time.
So, they are very different that way. Index funds already have disclosure, and I think more could be done with index funds to make them more transparent about how they are using their power. But at least we are starting with a base of existing disclosure requirements.
Private equity, on the other hand, would require a fairly dramatic change to start mandating disclosure from them. I think many of them will resist if this is proposed, as has been the case. However, I think the more thoughtful private equity firm managers recognize there is some value in greater transparency.
So, I think in the end, there may well be workable disclosure that could be developed for private equity, but again, it will be starting from basically nothing.
[Music]
A traditional investor-oriented disclosure focuses on ideas about risk and return, which is 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, and on the environment more generally. Water shortages and the like are often directly attributable to business activity.
So, disclosures about the impacts of companies can be just as important to the public as their investment returns. Again, because private equity is completely in the dark, we have very limited visibility into the impacts that the overall financial sector is having on the world, on the public, and on 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 the index funds will use their power to push companies to be more or less responsible about their social impacts, which 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 push 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 the focus of the struggle over how businesses are operating on the public company side has shifted to index funds.
What the index funds are doing will impact how Exxon, for example, affects the world. Private equity has several different aspects to the way it owns and manages companies. One aspect is that it typically borrows money. The debt 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 make interest rate payments.
That creates a sense of urgency and commitment to doing a better job with the company's assets. On the other hand, another aspect of private equity is that it is set up and designed to avoid disclosure requirements altogether. I'm not so sure that this is essential to the way the rest of private equity adds value to the economy.
At a minimum, after-the-fact disclosure of how private equity firms have run companies, the risks they have taken, and the returns they have generated would seem to be consistent with the private equity model. It 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 it has long gotten used to the idea that operating in the dark is useful. 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 are big enough. The U.S. is relatively unusual in having none.
[Music]
Disclosure practices are partly voluntary in response to market demand and 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. In fact, most companies above a certain size today already make disclosures about their climate impacts. The SEC is currently considering proposed rules to mandate those for all listed companies and is also working to get privately held companies to engage in disclosures.
Interestingly, 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. The question of how far the 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 are big enough and have enough operations in Europe, as many American multinationals do. So, in effect, U.S. companies 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 expansive as the European rules. California has adopted its own rules for companies that are active in California, which then affects another chunk of U.S. operations. That set of rules is being challenged in court, so we’ll see if it’s sustained.
What I think is most interesting about all of the regulatory interventions in the climate space is that even if you got rid of them all, most companies are already making disclosures about their climate impacts because investors are demanding it. So, I think the right way to think about regulatory involvement here in disclosure for public companies, 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 regarding disclosure.
[Music]
Famously, Louis Brandeis said the best disinfectant is sunlight, and the best policeman is an electric light on the street. While it's not entirely true that sunlight is the best disinfectant, there is some truth to what he used to say. That has been a mantra for disclosure regimes around the world for the last 100 years.
The idea is that by forcing companies to explain and provide information about their activities, 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 detail because shareholders will be able to see the linkages between what companies are doing and how the executives are being paid. Even if they might disagree with a particular choice, knowing they have to disclose what they are doing means that the pay packages are designed with investors in mind.
So, disclosure is a crucial element of effective corporate governance for any large company.
[Music]
The average American occasionally hears about private equity in mostly negative ways. They read headlines about problems and bankruptcies. Because private equity increases debt, it can increase financial risk, which can lead to bankruptcy. I think the average American, to the extent they are paying attention at all to the financial sector, is mostly hearing negative stories about private equity.
That's why I think some disclosure by the industry would be good for the industry itself. They could tell better stories about themselves if they had a better disclosure regime. Index funds, again, for the portion of the American population that invests, have become increasingly known. It is increasingly the way most people choose to invest.
However, I don't think most Americans understand just how much governance power index funds have, unless they live in a red state like Texas, where it has 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 an investment vehicle or sometimes in the political sphere. That is part of the point of the book: it is becoming increasingly a political problem for index funds that they are as big as they are.
[Music]
The idea that private equity would adapt the traditional way it invests to incorporate more ownership by employees and a broader number of people, in effect to share the wealth of the gains from the way private equity functions, is an interesting idea. It’s newish; it has not really been part of the standard private equity toolkit.
It is interesting that KKR is publicly embracing this as part of their overall strategy. I actually think it reflects the focus of the book, which is that private equity leaders who are more thoughtful understand the public is a little skeptical about what they do. This effort to broaden ownership within private equity-owned firms is partly a response to worries that they are making inequalities of wealth greater over time.
Whether it is enough or the right answer to all the challenges that private equity creates, I'm not so sure. I think there are some businesses where the scale of the business is such that it is unlikely the employee base will be able to own more than a small fraction of the equity of a company. But in professional services and what private equity does, it does seem like a promising path.
[Music]
Analyst calls have already begun over the last 10 years to include more questions about topics that generically fall under the umbrella of sustainability. I think that’s a growing recognition that investment returns over time depend on strategies and operations that are, in fact, sustainable.
It’s a discreet risk dimension that may have been 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 plants located in floodplains are going to face real risks that storms may interrupt their operations.
So, it would be reasonable and 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.
[Music]