How do private equity and index funds affect democracy?

The concentration of assets and power at index funds and private equity firms led one Harvard Law School professor to analyze the impact of economies of scale on American democracy.

With Vanguard, BlackRock, State Street and Fidelity Investments representing 20% of the proxy votes at S&P 500 companies, and private equity giants Apollo, Blackstone, Carlyle and KKR collecting more than $2.7 trillion of assets, former Securities and Exchange Commission official John Coates argues in a new book released earlier this month that investors and all Americans need greater transparency — without stifling the firms' innovation.

The growing power of the big index fund managers and private equity firms has attracted criticism in recent years from the political left and right alike. Many conservatives argue that some corporate actions are pushing liberal policies, while those on the other side view private equity as the tax-dodging wielding of cutthroat profits at all costs. Coates, a professor of law and economics who's a deputy dean of the law school, stopped short of calling for any firms to be broken up or prosecuted for supposed crimes. Instead, "The Problem of Twelve" explains how the firms amassed these assets and power over time and warns of their enlarging influence. 

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In an interview, Coates acknowledged that "I don't really have a solution" for what he described as "a deep tension" between the financial efficiency of consolidation and the concentration of power over the American economy. For private equity firms, he's "not expecting public company reports," but rather some degree of annual information disclosure "that would help them prove what they believe, which is that they're a wonderful thing for the economy," Coates said.

"Disclosure is a good thing; it's a good thing in part because it helps them demonstrate that they're adding value and not abusing value," he said of the index and private equity giants. "The power that they're accumulating ultimately really ought to be exercised by the people whose money they're managing."

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Coates' concise historical research could help financial advisors or their clients make sense of today's economy, and the book received praise from economist Lawrence Summers and from Allison Herren Lee, a onetime SEC commissioner who was acting chair in 2021. Coates was once the general counsel and acting commissioner of the SEC's Division of Corporate Finance and has previously been a partner at the Wachtell, Lipton, Rosen & Katz law firm.

"This is a must-read for policy makers and policy influencers on both sides of the aisle," Lee said in a statement for the book jacket. "Coates lays out — with deeply informed, thoughtful and near-forensic precision — the complicated balance of financial and political power in America, as well as ways to address the increasing concentration of wealth and the problems that presents for a thriving economy and democracy."

In examining index investing funds on the one hand and private equity firms on the other, Coates chose two areas of the investment world that "are quite different," said Jason Wenk, CEO of registered investment advisory firm custodian and technology company Altruist. At their root, "the best private equity investors are simply mathematicians," Wenk said in an interview, noting that the question of the long-term impact to consumers and the economy "worries me more" than the quality of their M&A strategies. 

As for the index firms, the rise of cheaper investments with greater access for more people has turned actively managed mutual funds into "the big losers" from the trend, Wenk said. Creating "a bunch of regulatory oversight and complexity" over them could add to their expenses without necessarily making anything better, he said.

"This is an example where, if you have an obviously objectively better product, assets will flow there," Wenk said. "It's hard to know what companies will do when they have that much power and they don't want to lose it."

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A 2021 shareholder vote by State Street and Vanguard in favor of activist candidates for the board of Exxon Mobil and a successful proxy campaign earlier this year in which Starbucks shareholders backed an independent study of the firm's labor practices demonstrated the power held by the largest asset managers, Coates said. While the four giants didn't vote in lockstep with each other or activists in either case, they held the balance of power.

"In a weird way, the danger is that they're so good that they take over everything," Coates said. "That's a political problem, because that means that they effectively can, if they are allowed to, control the way the bulk of the economy functions. … I am partly writing the book because I like index funds and I don't want them to be destroyed by the political system."

Coates' book also discusses how private equity firms essentially rebranded from their previous identity as "leveraged buyout" firms — a label that emphasizes the debt and takeovers that remain standard practice for the companies long after the "Barbarians at the Gate" of the 1980s. The firms are "now trying to pivot to 'growth capital,' which sounds even better than 'private equity,'" Coates said. He argued that the firms' approach doesn't fit industries like health care.

The private equity firms' emphasis on unlocking value from their vast portfolios is "not a great match for relying on the self-restraint and altruism that doctors have or nurses have or even, frankly, that journalists have," he said.

"The entire private equity business model is built around avoiding having to make portfolio company disclosures," Coates said. "The biggest concern I have about the rise of private equity is that it eliminates information from the public — both the investing public and voting public. That's a problem, because when times are bad and voters want some kind of response out of their politicians, the greater the secrecy, the lower the amount of information they have, the more likely the political response is going to be a bad one."