Capitalist markets often generate economies of scale in finance, which tends to concentrate wealth and power.
John Coates, from “The Problem Of 12: When A Few Financial Institutions Control Everything”
Over the past couple of decades corporate America has been increasingly owned by large Index funds (for public companies), and Private Equity (for private companies). This has resulted in increasingly concentrated ownership (a problem of 12) of these firms. For index funds this means meaningful voting control on shareholder resolutions and board elections. PE firms have brought capital and corporate style management to many companies that appear to be small businesses such as auto repair shops, dental offices, and assisted living facilities.
In “The Problem Of 12: When A Few Financial Institutions Control Everything” John Coates, a professor of law and economics at Harvard, takes a critical look at the growing political and social power of Index Funds and Private Equity. The premise is that the voting power (in the case of index funds), and political power (in the case of private equity) has resulted in a handful of individuals (Coates uses 12 as shorthand) having control and influence over a vast portion of the economy.
Index Funds
Passive Index funds have been a boon to investors, giving them low cost access to a diversified portfolio, as they have grown in popularity over the last couple of decades. Throughout my career as a financial advisor there was an increasing shift in the industry from building client portfolios with actively managed mutual funds toward passively managed index funds. This popularity and success in the marketplace has caused these passive investment firms to gain voting power and influence as they own a large percentage of company shares.
Coates uses the example of a 2021 Exxon Mobil proxy battle where an activist group was able to install 3 anti-fossil fuel members to Exxon’s board. The key votes? Blackrock, Vanguard, and State Street. Three large index funds with large percentages of ownership in Exxon.
In recent years index funds votes have tended to lean left on issues such as climate change, corporate governance (for example the race and gender compositions of boards), and other Diversity Equity and Inclusion (DEI) priorities. More recently these firms, Blackrock in particular, have been reversing many of their ESG and DEI positions. Either way, it is clear that through voting power these passive investment firms have greatly increased their influence over corporate America and the economy whether intentionally or not.
Private Equity
Private equity and private credit funds have become increasingly popular with high net worth investors and their advisors. It seems like every wall street bank is rolling out private equity and credit funds lately. These funds tend to be available to accredited investors only (generally $1 million net worth not including a primary home), which includes most clients of the large brokerage firms and RIAs.
Coates focuses on the growth of the availability of private equity as delaying IPOs and keeping companies private that may have been publicly traded sooner in the past. His argument is that large swaths of the economy are becoming opaque and difficult for investors and policy makers to evaluate. Like Index Funds, PE firms have grown significantly in market share over the past 20 years and most funds are concentrated with a handful of firms (Blackstone, KKR, Carlyle, etc.).
His proposed solutions boil down to mechanisms to get more shareholder input (in the case of index funds) and more disclosure and transparency (in the case of PE Funds).
My Thoughts
Overall, “The Problem Of 12” does a good job of laying out the economic and political problems that may arise due to having ownership of capital concentrated in too few hands. Coates proposes several interesting solutions that could address this problem while balancing the economic benefits that each of these institutions provides.
One criticism I have is that while they both represent increasingly concentrated ownership (the problem of 12), the Index Fund industry and the Private Equity Industry are quite different. The book loses some focus as it bounces back and forth between these two institutions. The author also dismisses the option of passing through shareholder votes to index fund shareholders as unworkable without exploring the pros and cons of this idea.
Get “The Problem Of 12” from your local library, or if you prefer to own the book here is a link:
The Problem Of 12: When A Few Financial Institutions Control Everything
If you have any questions, comments, or thoughts on this topic please contact me. I try to reply to as many emails as possible.
