The ‘Problem of Twelve’ — redux

Last summer Alphaville wrote a list of the dozen most powerful people of the investment world, inspired by a paper written by Harvard University’s John Coates that argued that “in the near future roughly twelve individuals will have practical power over the majority of US public companies”.

Coates is now back at Harvard Law School after a stint at the SEC, and the original Problem of Twelve article from 2018 has now become an entire book. It’s a fascinating subject, so we dug in and hopped on a call with him to discuss further.

The 2018 paper was focused on index funds, and that is the bit most people have freaked out about. After all, even Vanguard’s founder Jack Bogle raised the dangers of a narrow clutch of rapidly growing passive investment giants controlling more and more of the corporate world.

However, the book finally comes good on a promise made in the original paper to also explore the implications of the rise of private equity. It is the missing piece of the puzzle. As Coates puts it in the intro:

A “problem of twelve”* arises when a small number of actors acquires the means to exert outsized influence over the politics and economy of a nation. In US history, problems of twelve have recurred, as the result of a clash of two fundamental forces: economies of scale in finance on the one hand, and constitutional commitments to fragmented and limited political power on the other. Each time, the “problem” has been two-sided. The concentration of wealth and power in a small number of hands threatens the political system and the people generally, and the political response can threaten the financial institutions in which wealth and power are accumulating, even when those institutions create economic benefits.

Today, two late-twentieth century institutions — index funds and private equity funds — are creating a new problem of twelve. As financial organizations, they amass and invest capital, and have been primarily scrutinized through a financial lens. As with other financial institutions, they pool savings from dispersed individuals and channel it to fund major projects. They facilitate capitalism, which has created huge benefits for humanity — wealth, health, and much longer life spans — along with inequality, misery, and the existential threat of climate change. Finance creates value by facilitating change, but distributes the gains unequally, and magnifies the gales of “creative destruction.”

But both kinds of funds are now so large, and have influence over so much of the economy, that they have economic and political power, whether they want it or not. Their power makes them targets of political threats. Both institutions exhibit “economies of scale.” Both are active politically — directly, and indirectly — through their control of businesses.

Their growing and concentrated wealth and power threatens the foundations of a democratic republic built on Montesquieu’s separation of powers as well as federalism — the “checks and balances” taught to every civics student. In a predictable response, the republic is increasingly threatening each type of institution with new restrictions, burdens, and limits. Because index funds certainly, and private equity funds possibly, create value within the US economy, the threats to them are as important as their potential threats to American democracy.

“Potential threats to democracy” might be a little strong, at least in comparison to other, more obvious and direct threats that have cropped up in recent years? But the issue of increasingly concentrated corporate power is undeniable, even if most of the people that actually control that power are loath to even recognise that it’s there.

Measured by assets under management, the roughly $4tn in private equity is dwarfed in size by the approximately $20tn or so that resides inside index funds (though a small but growing chunk of this is in bonds, not equities). But the real power of private equity is magnified many times its AUM by the leverage the industry uses.

Together, they are a force to be reckoned with. Coates estimates that index funds and private equity collectively control about 30 per cent of US corporate equity, with private equity actually owning more than index funds.

And while index funds by their nature own a little bit of every public company, a private equity firm’s control over the companies it takes over is total. The Harvard professor therefore argues that the explosive growth of private equity could be even more problematic.

Alphaville’s emphasis in the excerpt below:

Private equity funds, such as Apollo, Blackstone, Carlyle, and KKR, are doing as much if not more than index funds to erode the legitimacy and accountability of American capitalism, not by controlling public companies, but by taking them over entirely, and removing them from the SEC’s disclosure regime. Private equity funds are creating their own problem of twelve.

. . . Private equity firms have moved beyond the buy-strip-sell model of the 1970s and 1980s to become a permanent, parallel capital universe. They now trade businesses among themselves, and have gathered assets at a rate that outstrips growth by public companies and the economy. While index funds are coming to dominate Berle and Means — style companies, private equity funds are shifting increasing amounts of wealth out of those companies altogether, into a separate system of ownership and control.

Private equity is in part a long-term strategy of regulatory avoidance. Private equity funds are intentionally structured so as not to trigger disclosure laws. The private equity industry helped shape those laws, with lobbying and political influence. Once a private equity fund acquires control of a business, the business goes “dark.” The results are less known to researchers and private equity professionals, much less to the public. General assessments of private equity are necessarily tentative. Yet we know enough about private equity to identify another problem of twelve in the making.

By the way, the “Berle and Means” mention above is a reference to Adolf Berle and Gardiner means’ 1932 book The Modern Corporation and Private Property, a seminal text in US corporate law that explored the schism between managers that run a public company and shareholders that actually own it.

Anyway, there’s plenty of detail on how index funds and private equity can exert their power and the quiet lobbying that happens — whether it is about ESG or more obviously self-serving reasons — and the backlash that has ensued.

The problem is that there aren’t any easy fixes, even if one agrees that there’s an issue here. As Coates writes (with Alphaville’s emphasis below):

Simple “solutions” to the problem of twelve — caps, bans, or complicated laws that assume individual investors can or will be willing to control the funds — are likely to be mistakes, and are unlikely to attract bipartisan support. Indeed, the size of the benefits of index funds, and the reasons that so much capital is currently managed by private equity funds, mean that the problem of twelve is better thought of not as a problem to be solved, but as a dilemma to be managed. In some ways, the problem of twelve is a double problem: it’s the threat posed by funds, and also the political risk posed by threats to funds. American history has produced episodes in which the political response to the growth of financial institutions was likely an overreaction, rather than an improvement. Any policy interventions should be cautious and provisional, and involve the delegation of authority to expert regulatory agencies, giving them the ability to adjust and refine how the law applies over time, as markets respond and evolve.

His main argument is that better disclosure — for example, on how index funds vote and why, and at least some public information from companies controlled by private equity — would at least improve accountability and legitimacy.

This may seem like a modest plaster to slap on the gaping wound. But at least it would be something. And doing nothing may not be a viable option, argues Coates (with our emphasis again):

Every generation or two, entrepreneurs create a new institution to capture economies of scale in finance. As the institution’s size and power grows, it comes to threaten democracy itself. How the political system responds to the threat is an important, quasi-constitutional choice. Extreme choices tend to be bad ones: if gridlock blocks any response, the threat only grows; if the political system kills or maims the institution, it also destroys the benefits the institution produces. Better to manage the threat with disclosure and public oversight, and to not let the perfect be the enemy of the good. Good responses to today’s problem of twelve will not be a permanent resolution of the tensions between democracy and capitalism, but they will lay a foundation for future generations to manage tomorrow’s problem of twelve.

We’re planning some follow-ups based on some of the specific issues we discussed with Coates, so watch this space.