A board on the floor of the New York Stock Exchange shows the closing number for the Dow Jones Industrial average, Tuesday, March 13, 2012. Private equity’s assets in 2020 had grown to 18 percent of total corporate equity. (AP Photo/Richard Drew)

In his new book, The Problem of Twelve, the Harvard law and economics professor John Coates writes that we’re “in a moment that is starkly different, if no less dangerous for democracy and capitalism, than the 1920s and 1930s.” At that time, the power accumulated by financial institutions—which Coates calls a “problem of twelve,” because those financial institutions were in turn controlled by a small group of men—was so great and so uncontrolled that it risked becoming a threat to both our political system and our economic system. Coates argues that although our modern too-powerful financial institutions look different than those in the Gilded Age, we once again face a similar—and little understood—issue of concentrated power.

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Today’s problem, he says, comes in two different forms: index funds and private equity firms. Index funds, which are a seemingly banal part of many investors’ portfolios, simply mirror the performance of a given segment of the market, like the big companies that make up the S&P 500 index. Private equity firms use a little bit of capital from investors and a lot of debt to take over existing companies. Both have grown dramatically in recent decades. Index funds now own more than 20 percent of large American public companies, Coates writes, while private equity’s assets in 2020 were 18 percent of total corporate equity, as measured by the Federal Reserve, compared to 4 percent in 2000. 

That growth, he argues, brings with it dangers, because at scale, both institutions are effectively countermanding the rules that are meant to bring transparency and fairness to the business world—the rules that allow capitalism and democracy to co-exist. Those rules, the most important of which were put in place in the wake of the crash of 1929 and during the horrors of the Great Depression, helped create a sense of oversight and fairness, which prevented capitalism from overpowering democracy and, in the process, destroying the very system that allowed it to flourish. But in the ensuing decades, Coates writes, many features of the New Deal that helped legitimatize capitalism were eliminated or reduced. 

Now, we’re once again at a point where Big Business and capitalism itself are facing societal skepticism. It’s an enormous issue, one that’s larger than this book, and Coates’s well-articulated argument that the power wielded by index funds and private equity firms poses a “legitimacy and accountability issue of the first order” may be an important and insufficiently understood slice of the problem. Ultimately, though, the conceit of the book is also its major flaw, because it’s not at all clear that index funds and private equity firms deserve to be lumped together. 

What became the very first index fund was founded back in 1974 by John Bogle, who started a firm called Vanguard. Bogle’s core idea, based on academic theory, was that picking individual stocks was ultimately a fool’s game, because the market would outperform most stock pickers. And there was a bonus: If you got rid of the stock pickers, you got rid of a lot of the expenses of running a fund, too. Bogle’s idea was “derided on Wall Street,” Coates writes. People called the fund “Bogle’s Folly.” But, of course, Bogle was precisely right. Index funds have helped millions of Americans save for retirement in a cost-efficient way. Hence their staggering growth. 

But as index funds have grown, they have accumulated a specific and dangerous type of power, Coates argues. The most important way that corporate America and democracy intersect is that investors in companies can bring forward a proposal—be it a management change or executive compensation—and ask for a shareholder vote. When you invest in a stock fund, whether it’s a traditional mutual fund or an index fund, your vote is in effect delegated to the people running the fund. The process of having millions of underlying investors cast their vote has been too complex and costly.

At the same time, because index funds benefit from economies of scale—the bigger the fund, the bigger the base against which costs are allocated, and the less any one individual pays—the market has come to be dominated by big index fund companies. As a result, Coates argues, those companies can dictate the future of much of corporate America. Today, he says, the big three—Vanguard, State Street, and BlackRock—control more than 20 percent of the votes of the companies in the S&P 500. If their current growth rates continue, Coates says the entire U.S. stock market will be owned by index funds by 2035. He argues that the small group of people who run these funds will “increasingly determine the outcomes of votes” on proposals brought forward.

“We have a new bunch of emperors, and they’re the people who vote the shares in the index funds,” Coates quotes Charlie Munger, the sage who is Warren Buffett’s longtime partner, as saying. “I think the world of [BlackRock CEO] Larry Fink, but I’m not sure I want him to be my emperor.” 

It’s a threatening prospect. But it’s not clear that Coates’s fears are justified. The complaint about index funds is generally that they do too little, not too much, a point that Coates doesn’t ignore. He argues that index funds’ failure to exercise the power they have results in a dangerous lack of any kind of outside governance mechanism across a large swath of American business. “In a political sense, index funds may present the worst of two worlds—concentration and the risk of too much power, on the one hand, but actual passivity and too little governance activity on the other hand,” he writes. Maybe. Passivity does pose its own set of problems, and power that has been accumulated can become power actualized at a moment’s notice. Maybe it’s just that index funds’ banality makes them seem more benign than malevolent. But at least today, the problem is mostly theoretical.

The modern private equity industry began not with the whimper of index funds’ underwhelming birth, but rather with a bang and swagger. In 1976, just after John Bogle created Vanguard, a firm called Kohlberg Kravis Roberts, or KKR, was founded with the premise that it could take over underperforming (and undervalued) publicly traded companies, fix them up, and return them to the public markets. The deals, like KKR’s 1988 takeover of RJR Nabisco, chronicled in the book Barbarians at the Gate, were known as “leveraged buyouts,” because companies were bought using a lot of debt, or leverage. By the end of the 1980s, the industry was mired in scandal, and the firm Drexel Burnham Lambert, which sold many of the bonds used to finance the deals, had gone bankrupt. 

Between then and now, the firms managed to pull off what Coates calls a “brilliant, deceptive rebranding.” Their business was the innocuous-sounding “private equity,” not leveraged buyouts! But the rebranding masks the fact that the reality is the same. Private equity firms operate by using a little bit of investors’ money and a lot of debt. The debt may precipitate bankruptcy, like in the well-chronicled case of Toys “R” Us, or it may lead to reprehensible cost cutting, like when private equity has taken over hospitals and nursing homes. Even when the outcome is better than that, Coates argues, what private equity does is dangerous too, because at scale, it removes a large swath of corporate America from the disclosure requirements—the transparency, and thus the legitimacy—that come with being a publicly traded company. 

Unlike index funds, which have grown because they’ve performed so well for ordinary Americans, it’s also not clear how well private equity firms have performed for their investors. “No general consensus exists that private equity is currently adding value for even its own investors overall, much less for society as a whole,” Coates writes. Its “primary contribution,” he says, quoting another researcher, is “cheap debt financing.” It is, however, perfectly clear that the people who run the funds have done very, very well. Steve Schwarzman, who founded Blackstone, and Leon Black, who founded Apollo, are multibillionaires. 

People called the first index fund, Vanguard, “Bogle’s Folly.” But, of course, the founder, John Bogle, was precisely right. Index funds have helped millions save for retirement in a cost-efficient way. Hence their staggering growth. 

The growth of private equity funds, like index funds, has been nothing short of staggering. Coates reports that today, more than a third of total corporate equity in the U.S. is managed outside of public companies, with the fastest growth in businesses owned by private equity funds. You might ask why the stupendous growth if there’s a debate about the performance. Coates calls it a “mystery.” One reason is the availability of low interest rate debt in recent decades; another related reason is that pension funds, desperate for returns, have poured money into private equity firms. The “dark” nature of companies owned by private equity funds gives the fund managers a fair amount of discretion over the returns they report. After all, there’s no public market measure of the value of a company that has been taken private. Everyone likes this. The private equity firms get to pretend to be investment gods, and the pension funds get to avoid admitting that the value of their investments has declined. But it only works if the dips are short term. 

Another factor in private equity’s growth has been the political power the industry has amassed. One of the key rule changes that Coates argues helped fuel the industry’s rise came in 1996, when President Bill Clinton signed a law that allowed funds to raise unlimited amounts of capital from unlimited numbers of institutions or individuals, as long as those entities had at least $5 million. Before that, funds were limited to 100 investors. Suddenly, the brakes were gone, and entities like pension funds could put the money belonging to teachers or firefighters into private equity. Coates calls 1996 “an exemplar of Bill Clinton’s initiatives that benefited financial interests at the expense of the public.” 

Such rulings, Coates argues, mean that there isn’t really anything private about private equity. “The capital put at risk by private equity firm owners is just as much ‘other people’s money’ as it is when invested in public companies,” he argues. “The primary way private equity is private is that it is clothed in secrecy.” 

“No general consensus exists that private equity is currently adding value for even its own investors overall, much less for society as a whole,” Coates writes. It is, however, perfectly clear that the people who run the funds have done very, very well.

Today, private equity’s political power is visible in the inability of the government to get rid of the so-called carried interest exemption, which allows the investment income flowing to the private equity firms’ individual owners to be taxed at the preferable capital gains rate, rather than the ordinary income rate. Coates notes that Biden’s Inflation Reduction Act didn’t pass until a provision that would have taxed carried interest at the regular rate was removed. It’s a concrete example of something that delegitimizes the supposed aims of the Democratic Party.

On top of that, private equity increasingly looks like a sophisticated version of a shell game. Coates reports that since 2018, half of all sales of private equity–owned companies have been … to another private equity firm. Despite the advantages that private equity honchos tout about being private instead of being subject to the disclosure regimen of the public market, Coates notes, since 2007, nine of the big private equity firms themselves have sold stock to the public. This is either a sign of hypocrisy or a sign that the long con is coming to an end. Who will be left holding the bag? Guess.

Coates is a clear-eyed and at times delightfully sharp-tongued chronicler and historian, and his observations are powerful. But the solutions he proposes are tepid. “Any policy interventions should be cautious and provisional,” he writes. His ideas pretty much boil down to more disclosure and more public oversight because, he says, we don’t want to take away the value provided by index funds and private equity firms. He writes, “The threats to them are as important as their potential threats to American democracy.” 


Maybe this is true of index funds. If they were smaller, their costs wouldn’t be as low, or as Coates writes, “A clear trade-off exists between the benefits flowing from economies of scale, and the risks to political economy of scale and concentration.” Given how little today’s big index funds exercise their power, you can make a case that additional disclosure, perhaps some real-time method of accounting for if and how index funds cast their votes, would suffice. 

Private equity is a different story. The benefits aren’t clear, and even if they were, Coates doesn’t make a case for why bigger private equity firms are better. While his view of the societal risk of private equity is compelling—removing large swaths of corporate America from the disclosure requirements that come with being publicly traded does result in a loss of transparency—he doesn’t mention the more damning problem. When Americans read about companies going bankrupt and employees losing their jobs while private equity firms make hundreds of millions of dollars, our faith in capitalism is undermined. And when the government sits by silently while this happens, our faith in democracy is eroded as well. 

The most depressing part of Coates’s book isn’t that his prescriptions are so timid. It’s that even those might not be doable. Even mere additional disclosure mandates will be “stoutly resisted” by both sets of institutions, he writes. 

Indeed, despite the noises the Biden administration has made about more aggressive antitrust enforcement in the overall business world, nothing much has happened. Is it too much to expect the government to take action that would be upsetting to the people who run index funds and private equity firms? Well, yes. Which, if you believe Coates, may mean that the fate of our economic and political system could rest on the willingness of powerful people to offer up their own reforms, to understand that what the country has given to them can also be taken away, and not necessarily in a democratic manner.

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Bethany McLean is a journalist, the cohost of the podcast Capitalisn’t, and the author of several books, including the forthcoming The Big Fail: What the Pandemic Teaches Us About Who America Helps and Who It Leaves Behind.