Capitalisn’t: When a Few Financial Institutions Control Everything

John Coates: When you have that small number of people controlling this big a portion of the economy, there’s always a risk that they will do things that are in their own interest or, at a minimum, just not in the interest of the public at large. That is a real democratic deficit for capitalism.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Luigi: I wonder if listeners could guess the one topic where Bethany and I disagree the most.

OK, it’s pretty obvious, it is private equity. This might be an overstatement, but Bethany thinks that private equity is evil and represents everything that is bad in the world. And I have more mixed views. I think that there is some that is evil and some that might actually be good.

Bethany: Well, it might be an overstatement to say that I think private equity is evil, but modern, big private equity, maybe so. When Joe and I reported our book, The Big Fail, I was really struck by a study showing, basically, that private companies bought by private-equity firms are 10 times more likely to go bankrupt as those that aren’t.

As I think our listeners know, I’m a believer in capitalism, but I’m a believer in an old-school kind of capitalism, where people make money—even fortunes, yes—because they build a business that provides jobs for other people and services and goods that the world needs, not because they destroy the business and the jobs.

Luigi: But Bethany, you know that most people die in bed. It doesn’t mean that sleeping is a dangerous thing to do or lying down in bed is dangerous. It is that you’re more likely to lie down when you’re about to die.

Private equity, most of the time, intervenes when things are really bad, and so, I think that the fact that it is associated with a lot of bankruptcy is not that surprising. Now, this is not saying that there won’t be some evil in private equity. I don’t want to defend the entire category, but just saying that companies are 10 times as likely to go bankrupt is kind of the nature of the beast. I don’t think it is a proof of their evil.

Bethany: Yeah, that’s an interesting argument, and I think you would have to go through examples almost on a case-by-case basis. But I have been really troubled over the past 20 or so years by the rise of something known as a dividend recapitalization, in which a private-equity firm . . . The very definition of private equity is that it takes a company private using a great deal of debt. It adds more debt after the original deal in order to get cash, and they add this debt to the business, not to reinvest in the business but to pay themselves a dividend.

But here’s the thing for our listeners: when Luigi and I were mulling episode ideas, we actually found something about private equity on which we agree. “Private” is a misnomer, in my view, because not only do private-equity firms control so much of the market today, but their underlying investors are often teachers, firefighters—in other words, ordinary Americans who are invested in private equity through their pension funds.

If the underlying investors are the same as the investors in your publicly traded company, why does private equity get to be private? Luigi, I’m not sure that would be your argument for why “private” is a misnomer, but I think you agree with that issue, too.

Luigi: Yeah, I agree very much that society is not well served by the secrecy of private equity. We honestly don’t know what is the real return or the risk-adjusted return on this investment. As a result, the entire allocation of capital in the economy is hampered by this lack of knowledge, and the weaker institutions in this game are losing out.

I’m not worried about Yale’s and Harvard’s endowments, because they’re doing very well in private equity. My favorite example when I teach this stuff is referred to as the Wisconsin Fireman’s Retirement Fund. I don’t know whether it exists or not, but it’s a hypothetical fund that is lured into private equity. They are not particularly good at benchmarking, and they might put their money in the wrong places. I think that’s a cost for them, but also, it’s a cost for society at large, because the money is not well utilized.

Bethany: I’d previously reviewed Harvard Law Professor John Coates’s book The Problem of Twelve—and we’ll get back to the title and what it means—for Washington Monthly. I was struck by his observations on this topic. Coates wrote, “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. The way private equity is private is that it is clothed in secrecy.”

And so, here we are today, and private equity is expanding into something called private credit, which is basically the business of providing financing to companies using funds raised from investors, not in the public-debt markets. Big private-equity firms like Blackstone and KKR are rolling out products that are marketed to well-off investors, and these firms are going public themselves. It seems more and more absurd that they get to be private. I also start to worry that when you see these things, it means the party is about to end, and guess who’s going to be left holding the bag.

Luigi, I know what you’re going to say to me, which is that private equity is not all that Coates’s book is about, and that it actually might be about something entirely different, really, than private equity.

Luigi: Yeah, I read this book as being about concentration in financial markets, not just about private equity, because it also discusses index funds that are simply funds that are not active, so they’re not picking stocks, but they are replicating an index like the Standard & Poor’s 500 index. They’re very cheap, but they’re so cheap that now they are becoming the primary form of investing for a lot of people, and so, they have a disproportionate amount of money and voting rights under control. I regard the major theme of this book as concentration everywhere.

Bethany: Coates’s argument is not just that private equity poses a problem or that index funds pose a problem. It’s that they have become so concentrated. He argues that index funds now control somewhere between 20 percent and maybe even over 30 percent of the votes of American corporations and that over the last 20 years, private-equity funds have grown from around $770 billion of global assets under management to $12.1 trillion, which means their growth was four to five times faster than the growth of the US economy as a whole.

His argument isn’t just that private equity is bad, or index funds are bad. In fact, he actually doesn’t argue that at all. His argument is that the size of the two of them is what’s problematic.

Luigi: When it comes to private equity, one of the points that Coates makes, which is very important, is that they might actually be so large that they might gain market power. Recently, the Federal Trade Commission brought a suit against Welsh, Carson, Anderson & Stowe, who did what is called in jargon a roll-up of anesthesia partners in Texas.

A roll-up is when you buy a lot of little practices, and you put them all together, and because they’re small, there is no antitrust review. Then, by the time you have bought them all, you get huge market power. You know, when you go into surgery, you don’t pick your anesthesiologist. The person is just assigned to you, and so, they set the prices, and the prices are incredibly high. Hopefully, you don’t have to go into surgery, but the next time you go to the hospital, and you see a surprise billing, part of that surprise billing might be due to the market power of private-equity firms.

Bethany: So, who better to discuss why private-equity funds get to be private and why your banal index fund actually poses a threat to democracy than Coates himself?

I thought we’d start with a pretty basic question. What is The Problem of Twelve, and what made you start working on this book?

John Coates: A few years ago, I was teaching at Harvard Business School, and they asked me to do a little primer for their MBAs on what are the big things that are ongoing changes to US public-company corporate governance. The big things that have changed the most are the rise of index funds and the rise of private-equity funds. Both types of asset-management companies enjoy pretty powerful economies of scale, so as they get bigger, they get better, and as they get better, they get bigger.

The resulting concentration in financial markets might raise traditional antitrust concerns, but that’s not really what I mean by The Problem of Twelve. What I mean by it is power over the economy. It’s not intentional—I don’t think anybody in either industry ever set out to get that much concentrated power—but it is true now that less than a dozen people across those two industries control in excess of 25 percent to 30 percent of all the equity of every US-listed company. That’s index funds. And 25 percent, roughly, of nonpublic equity is controlled by the private-equity industry and a small number of players in that industry as well.

That means when things don’t go well in the economy broadly, there is a perceived gap between the accountability and the legitimacy of how that economy is being run. It’s sort of a double problem, at least for index funds. I like index funds, to be clear, as a financial product. I use them, I think they’re wonderful, I think they drive down fees, I think they do all kinds of great financial things, but they’re so good at it, they’re producing real political risks for themselves.

The other side of the problem is when you have that small number of people controlling this big a portion of the economy, there’s always a risk that they will do things that are in their own interest or, at a minimum, just not in the interest of the public at large. That is a real democratic deficit for capitalism, to be perceived as being oligarchic in that way.

Luigi: I’m a hundred percent with you about the political cost, but very often people push back, and while everybody understands market power very clearly, can you give us a couple of examples of real political power that is different from market power and something that you are personally concerned about?

John Coates: The classic war story for index funds now is the Exxon proxy fight from a couple of years ago, where, for the first time in the history of the world’s largest oil company, the current board didn’t get to pick the board. A tiny little hedge fund that nobody had ever heard of before ran a slate that, 15 years ago, wouldn’t have had a chance in hell at getting elected.

How did it win with 0.01 percent of the stock of Exxon? It won by convincing the major index funds to support three of the four candidates, who then got elected. They’re not the only ones who voted in favor, but they were outcome-determinative.

The key point is, without the index-fund concentration, that hedge fund would have had to make its pitch to hundreds of dispersed asset managers and thousands and millions of dispersed individuals and almost certainly would have lost, but for the concentrated ownership of the index funds. That’s on the index-fund side.

As a more recent example, pending right now, there’s a proxy fight going on at Starbucks, run by labor. My bet is that it probably won’t work, but it has a chance, and it has a chance, in part, because they convinced State Street to support one of the initiatives last year, or a year ago, on disclosure related to labor treatment. That’s interesting, right? That’s a different kind of way in which labor is using different tools to pursue its ends.

Certain folks who don’t like labor power will view that with great horror, and those who love labor will think that’s great, but either way, it’s power. It’s a type of power channeled through the index funds that was not there previously. Private equity—

Luigi: Can we stop there for a second before you go into private equity? Sorry, Bethany, I want to interrupt, because I think that the two are a little bit different, so I think it would be useful to separate them.

In that particular example, I’m not so sure that I see it as a negative. Over its history, the board was self-perpetuating with no input from the shareholders. The fact that, all of a sudden, there is more concentration that pays more attention and gives more feedback, I see overall as a positive, not as a negative.

John Coates: I’m fairly careful in the book to not necessarily describe any particular outcome as good or bad. I happen to think climate change is caused by humans, and we should be doing something about it, so all in all, I kind of like the fact that the Exxon board now has on it somebody who knows more about sustainability than they used to have. I could go through a list of other outcomes that I’m happy with, where the index-fund power has been brought to bear.

On the other hand, I can give you examples where I don’t agree with it. They’ve all, largely, failed to back—and here’s something I think you care about, Luigi—a disclosure of corporate-level political activity and resolutions brought to get companies to be more open about how the corporations, like Exxon, are using their power in the political system. The index funds have not supported those proposals. That’s the reason they’ve not passed.

The key point, then, is not so much good or bad on any particular outcome, but they’re the players. It’s a dozen people or less at these index funds who are deciding, one way or the other, whether Exxon’s going to go greener or not, whether Exxon’s going to disclose how much money it gives to the state-level AG organizations, whether Starbucks is going to be nice to its labor unions. I can go down the list.

So, it’s neither necessarily good or bad. Do we like a world better where Exxon’s board is immune from shareholder pressure or a world where a few people at Vanguard, BlackRock, and State Street can force them to change? Neither of those is clearly better or worse to me from an overall welfare perspective, but they’re very different worlds from a power perspective.

One other way to think about this one is, since the 1940s, we’ve forced regulatory agencies to be somewhat open and engage with the public in the United States before they pass rules. These index funds are functioning a lot like governmental agencies, but they have no public overlay of required engagement with their very dispersed owners—whose money, by the way, they’re managing, right?

That’s where the power comes from. If this were their own individual money, we’d have a different conversation. But this is power derived, and it’s very much accidental. None of us gives our money to Vanguard thinking, “Oh, they’ll be my political representative.” It’s just a sort of side effect of their incredible efficiency.

Luigi: It seems to me there is a very simple solution to the problem you’re describing, and some are already implementing it, which is pass-through voting. You give the ultimate power to vote to people who own this stuff. To simplify this, either you have some guidelines, or you organize some representative assembly.

We had on our podcast Hélène Landemore, who is a big supporter of these citizen assemblies. If you want to get the opinion of people without costing everybody a lot, you can simply have a random representation of your investors in the index funds who decide what to vote on political disclosure, on the environment, and on animal welfare. I see this as an enormous improvement—more democracy rather than less.

John Coates: I’m generally in agreement with that direction, but here’s where the country lawyer is going to say to the financial economist, “Yeah, that’s not so simple.” I think it’s a 10- to 20-year, pretty heroic effort, to get close to the vision that you just painted.

Let’s be clear, pass-through voting as currently being rolled out by the big guys, it’s not that. They’re not passing the votes through, except institutions like BlackRock can do that because a big chunk of its money is to big institutions, so that’s easy to work out. The bigger problem is to retail, which is still most of the money for Vanguard.

Here’s the challenge: 4,000 companies, a couple of shareholder resolutions and a hundred contested elections and other issues per year, millions of investors with similar but not exactly the same portfolios. How do you take all the information relevant to that and reduce it down to a simple-enough form that your typical retail investor will be willing to engage, other than on the margin?

Now, even some engagement is a political gain. It helps diffuse the sense that there’s just 12 guys in a room deciding everything. But to really create that modern, electronic-democracy idea, there’s got to be things a little bit like political platforms and parties and reduction of that complexity.

I think it’s going to be a long, complicated push-pull. They’re going to want to say they outsource all the true power to their end clients, but they’re not really going to want to do that. When it comes to a merger vote where a lot might turn, then they’re going to face pretty strong fiduciary-duty pressures of their own to hold onto that power and not just throw it open to whoever happens to show up to vote.

There’s also going to be a risk that the craziest people from either end of the political spectrum will be the only ones to show up, and so, if you build a system that lets them have outsized influence, that’s probably worse than the status quo.

And then, finally, the biggest challenge, frankly, is technological. Here’s a fact that very few people appreciate: until this year, this past calendar year, even through a normal broker channel, you could not get a confirmation back that your direction down to the broker, down to the client, down to the bank, to DTC and into the voting system was voted the way you wanted.

For the first time in US history, they finally got a system to allow that through brokers. Now, transpose that to a fund. The fund owns stock in Exxon, the fund raises money from a 401(k), which in turn is sponsored by a dentist’s office, which in turn has 12 employees, and you’ve got layers and layers up and down to push these instructions through. They do not have the technological capability to do that today, and it will be very expensive for them to build this.

And, finally, there’s a real trade-off here. The more elaborate the governance system you build, the greater pressure you put on the whole index-fund model, which is to keep costs as low as possible. There’s going to be a really tough trade-off, at the end of the day, between how much true pass-through we want versus how much money we are willing to spend with the technology. I do think we’ll get there, but I think it’s going to be, as I say, 10 or 20 years before anybody really puts all that together well.

Bethany: Index funds seem like power that could be exercised, and maybe there are some examples of it being exercised, but it doesn’t seem quite as possibly malevolent as private equity in terms of the damage to our system. At least index funds have been good for investors. They’ve been the right call for investors over the years; they’ve been a great innovation.

It’s unclear that private equity has been that. They’ve done damage to swaths of the economy and there are these . . . I’d almost break it into two parts, and tell me if you agree with this about the lack of legitimacy. One is that it’s not private anymore, a point you make very eloquently. There’s no way in which this should be considered private. But also, just watching so many people or this handful of people make so much money from deals that leave swaths of the economy in trouble is another form of delegitimizing capitalism. So, I see the commonality, but the differences seem so big to me.

John Coates: It’s fair. They present similar problems. When you pivot to solutions and specific kinds of threats, they get very different. And, just to be clear, index funds are already subject to significantly more regulation than private equity by design. Index funds disclose their votes, they disclose their holdings, they disclose their governance system, et cetera, et cetera.

Private equity has done a very good job of convincing Congress to exempt them from disclosure regulation, so we really don’t know how they function, except through enterprising journalists and the occasional whistleblower and occasional bankruptcy cases.

The place where I depart a little bit from standard critiques of private equity is I think the industry is actually very different across different sectors and types of funds. And I, personally, think the biggest threats that private equity poses—although, fair point, we don’t really know because of a lack of disclosure—is in sectors where law is not that great.

In medical services, we rely on professionals and their own socialization into a set of norms that prevent them from sacrificing patient health for profit to limit the damage that certain healthcare setups can do. Now, it’s not to say doctors are perfect. They’re not, and there’s ways in which, certainly, they’re always tempted to also engage in malpractice. But you add private equity to the mix, and you change the nature of governance over those medical professionals . . .

I think private equity’s model is pretty good for a widget manufacturer: buying and selling and you want to get costs down and get efficient. There, I’m in favor of private equity. But when it comes to places where you can’t regulate the behavior very well, I think private equity is a recipe for disaster. It generates incentives to externalize harm as long and as strongly as you can.

Before we get to that, we need more information, and I think private equity itself . . . The leaders get this. If you interview the leaders of the top private-equity complexes off the record, they would grant that they have a PR problem, and they would be willing to embrace more disclosure to help deal with it. Now, that’s a negotiation, and I’m not predicting how that will come out. But I do think even they see that, in the long run, they’re facing a collective-action problem, where some of their worst sector actors are going to end up generating bad political winds for all of them, unless they do something to address it now.

Bethany: I hope you’re right. That might be the most optimistic thing I’ve heard in a while.

John Coates: I try to be optimistic.

Bethany: You write really eloquently about the problems with private equity, about the fact that the only thing that’s private about this business is that it’s very secretive because a huge chunk of the investors are through pension funds, and they’re just the same people who are invested in the stock market.

And now, you have firms like KKR and Blackstone rolling out products that are marketed specifically to well-off investors. More and more, the idea of “private” is a distinction without a difference, even as the industry expands dramatically now into private credit and makes up more and more of a share of merger-and-acquisition volume each year.

Why isn’t the solution just to get rid of the distinction and say, “OK, if your company is bought by a private-equity firm, you still have to file with the SEC, and you, private-equity firm, whether you’re public or not, you also have to file your investor letters with the SEC”? Because there’s nothing that’s private about this.

John Coates: As a pure policy matter, I think you make a pretty good case, and I embrace it. As a political matter, the SEC passed what, honestly, are pretty light tweaks to the private-fund industry regulation this past year over the vehement objection of a combination of hedge funds, private-equity funds, venture-capital funds, and their trade representatives.

The SEC has been sued, for that rulemaking in the Fifth Circuit, which is partisan and highly likely to come out in favor of the trade group. The lead plaintiff is a new trade group that was set up in Dallas, according to The Wall Street Journal, in order to bring this lawsuit, in order to get jurisdiction in the Fifth Circuit.

They’re very smart. They’ve been playing this narrow, little game with the SEC’s rules from before it was even on the SEC agenda, and they were ready to go with the lawsuit the moment the rule got finalized, and they have a decent shot of winning in the lawsuit.

If they win, depending on how the court writes that decision, the SEC’s current authority to do anything might very well be significantly curtailed, even from the plain text of the ’34 Act, which is the basis for the SEC’s authority. That’s under current law with our current, highly dysfunctional litigation system layered on top of it. To do what you want to do clearly would require an act of Congress.

To state why I think it’s a good idea beyond the points you made, no other country does it the way we do. Every developed economy says, above some scale, we need disclosure. It doesn’t really matter what the ownership structure is. It doesn’t matter whether it’s nominally one owner or 10 or a fund with a hundred or a fund with a thousand or a million stacked on top of each other. If it’s above some size, if it’s got a big enough role in the national economy, then there ought to be some basic disclosure about that portfolio-company-level operation. And then, funds also are regulated and have disclosure obligations once they get above a certain level of size.

From a political-economy perspective, I think that’s pretty commonsensical, but it will push against 120 years of US legal tradition, and the Republican Party would probably be united by fewer things. And, frankly, the Democrats, too . . . Let’s remember, it was Schumer who helped keep carried interest from being taken away, so they’re pretty good at the political game, too.

In the short run, given the difficulty of legislative change and given the difficulties the SEC has had already just doing modest changes, I think the more promising thing, actually, is to focus on the pension-fund layer. Part of the problem is that the pension-fund managers, frankly, are not up to the task of engaging with the private-equity industry as investors. People think they are, but they’re not.

There are more of them, and they’re in different states, and they’re regulated at that level, and so, there’s some greater openings there for change, I think, that can be completely neutrally defended. We want to make sure that the taxpayers are not going to have to pick up the deficit when the pension-fund investments run short, and how are we going to know that? We need to understand what they’re doing. We need to know more about what they’re investing in, and that’s private equity, increasingly, these days.

That’s an avenue in. Of course, the private-equity industry could eschew pension fund money and say, “We don’t want it anymore,” but that would be hard for them. So, I think that’s probably a politically viable path, more so than getting Congress to do anything.

Having said that, the one opportunity will be if we have a significant recession coupled with a massive turndown, coupled with massive write-offs. Eventually, private equity will have to realize gains or losses, and that would be another political moment where, potentially, we could have some sensible disclosure changes.

Luigi: Why don’t I try a slightly different avenue? When you look at other countries, one of the considerations that people have is that in many of the mostly developing countries, you have these large conglomerates who have too much power. Even in the United States, in the late ’60s there was a famous conglomerate merger wave, and at the time, a bunch of people started to raise issues that maybe those conglomerate mergers are a violation of antitrust.

Since then, we have developed an economic theory of multimarket contact. The simpler way to say it is that it is much easier to sustain tacit collusion if we have contacts in multiple markets. If I control three large firms in three different markets, and you, as the private-equity firms, control three other firms in the same three markets, even without talking, we can agree on higher prices in a much more effective way.

So, why don’t we start looking seriously at the market power that these large conglomerates have, because this is what they are, right? The private-equity firms are large conglomerates, with all the defects of the conglomerates. One is market power. The other is political power, because they make it much easier to administer reward and punishment to every politician and every regulator on the face of the earth.

Even limits to the revolving doors don’t work very well, because you can hire people in a different industry, and so, you don’t see it, but I am able to reward people who go my way and punish people who don’t comply.

John Coates: I am in favor, too, of using a more flexible approach to antitrust to take on concentrated power. US antitrust law used to have this character. You alluded to it in possible applications in the ’60s. Even going back to the ’50s, there were uses of antitrust in places that probably wouldn’t happen today.

Luigi: Wait, wait, but the law has not changed. The law has not changed. It’s only the lawyers who changed, so we can change them back.

John Coates: Well, but the way they changed was, the business community invested massively in funding very well-paid vacations in Florida for the federal judiciary, where they were lectured to by University of Chicago law professors about why antitrust was only good if it was only focused on consumer welfare, narrowly defined, with a very particular approach to market definition. And that, unfortunately, has gotten baked into our case law.

One of the perverse things . . . I love the common law, I like the way it works, I think it’s a wonderful human invention, but one flaw it has is it relies on precedent in a kind of stupid way. If a judge decides in 1975 that he’s been convinced by Henry Manne that the right way to think about antitrust is this way, then he writes an opinion reflecting that view of economics.

Ten years pass, the economists keep thinking and go: “Actually, you know what? That Manne view was just dumb. The model was silly. He had made some totally inoperative assumptions.” Our models today are much closer to the kind, Luigi, that you’re sketching as legitimate pictures of reality. But the law has now baked in that Henry Manne view from 1975, and so, it does not update to keep up with the current thinking in economic schools.

Luigi: But I think you’re too negative about common law and too positive about American democracy because you can easily overturn precedent. When it comes to abortion, it was overturned. I don’t think it’s that difficult to overturn a precedent if there is a political will.

The problem is not that they can’t. The problem is that the system has appointed to the Supreme Court a bunch of people who are completely convinced of the opposite. And this has been done, as you point out—I think not enough—in your book . . . I think that most people are not that familiar with the Powell Memorandum. I’m obsessed by it. You mentioned it in passing, but I think it’s a very important moment that indicates how business really got together to change the Supreme Court in order to protect its interests. And every problem in American democracy starts there.

John Coates: I’m with you, but that’s exactly why it’s going to be hard to change. And let me ask you this, if I could make George Soros write you a check for a hundred million dollars, and you wanted to drop that into activism of some kind, one choice would be to say, we’re going to try to drop it into retraining federal judges. We’re going to have our own bootcamp, and we’re going to bring them to a better place, an even warmer place, and teach them updated antitrust economics, and then they will go back.

We don’t need to change the Supreme Court. We just need to change the minds of the federal judges who are at least open to a good trip and some presentations. That’s basically what the corporate sector did to bend antitrust the other way. Could we redo that in the other direction?

Would you drop it into political campaigns to elect a president and a Senate that could change the composition of the Supreme Court, which would then, top-down, try to change the minds of judges? That’s a different tactic.

I can’t game that out. Law professors tend to be very risk averse, so I would be very diversified across all the tactics and say, we’ve got to do all of them, because I don’t know which one is actually going to pay off.

Luigi: I would invest a hundred million in changing the way corporate votes takes place, because if we start having shareholders limit corporations using their money to pursue a particular agenda and make them be more transparent in what they’re doing, we can fix the problem at the root.

If we cannot succeed in that, I think every other avenue is lost, and honestly, a hundred million to elect the president is not going to be enough. The campaign is $2 billion, so with a hundred million, maybe you can elect a senator these days, a couple, but I’m not even sure.

John Coates: Sadly, true. I would say the single most disappointing thing to me about the index-fund industry has been their resistance to political disclosure. I don’t give financial advice, and this is not meant to encourage anyone to change their patterns of investment, but I would not now have put all my money in Vanguard if I’d known that that was the position they were going to take. And now, it’s tough to find zero-basis-point ways to invest your money safely and diversified.

There are some other options, and I do think that this will be a place of interesting competition over the next few years. Can any of the big three or big four, big five, depending on how you think of them, position themselves to respond to your question to gather assets? I think they can. I think people are beginning to realize, “Oh, when I invest my money into a commodity product, and I can get some of the political goals I want or not, I’d rather get it.”

Go back to reducing the complexity of what the choices are about. This, to me, is first order. If you can’t get good information about how the political system is working, nothing else works. So, I’m with you.

Bethany: I did find him more compelling on the subject of solutions in the podcast than I did in his book because I did come around to this view that transparency really is the critical thing here. But I also found really disheartening his stories about how opposed to any kind of transparency private equity and index funds are, that this isn’t something that they’re actively embracing—even though, I guess, I also did find it somewhat encouraging that, at least privately—which is ironic—people perhaps are a little more conciliatory than they are publicly.

Luigi: I think that for index funds, there is an enormous political pressure to do something, because index funds have been caught between a rock and a hard place on the issue of ESG, on the issue of the environment, and then, social proposals at shareholder meetings. They are actively trying to pass through the vote to the ultimate owners, precisely to shed some of the power. I think that politically, it is untenable for them to maintain all that voting power without anything changing. I am not that worried about the political dynamic there because it’s already working through very effectively.

By contrast, I think that private equity does not have a clear pressure point, because you don’t see, for example, Republicans being upset about anything private equity does. Even the Democrats seem to be pretty much in bed with the industry. I don’t see the political pressure and I see, really, a much, much bigger issue from an antitrust point of view.

In the case I was describing in the introduction about the anesthesiologists’ offices in Texas, one of the defenses of the lawyers was, “Oh, you cannot conspire between a company and its subsidiary.” This is a case back in the ’80s. The language of the Sherman Antitrust Act is “conspire to restrain trade.” You cannot conspire to restrain trade between a parent and subsidiary, because they’re one and the same thing.

But then, they are saying that in private equity, a controlled company and the parent company are one and the same thing, which means that Blackstone or KKR are gigantic companies much bigger than most of the companies we know.

Bethany: Yeah, yeah. No, they really try to have it both ways, in a way that is incredibly frustrating and intellectually dishonest. You saw that in the pandemic, too, where private-equity companies tried to lobby to get their portfolio companies to have a piece of CARES Act money, and basically, they said, “No, no, no. These are all small businesses. They need CARES Act money.”

But then, they also said, at the very same time, “Look at how many people private equity employs now, what a big swath of the US economy, and we invest on behalf of all these teachers and firefighters, so you have to save our companies.” They’re trying to use their size as an advantage when they can, but they’re also trying to hide behind their portfolio companies.

I’m finishing a very dispiriting piece right now about private equity’s forays in the hospital business, and one of the private-equity firms in question, when I called them for comment, said: “No, no, no. This is our portfolio company. You should call our portfolio company. All the decisions were made by them.” Despite the fact that everybody knows that the portfolio company is controlled by the private-equity firm. And I almost said, “I’ve been doing this for 25 years, please don’t try that on me.” It was so infuriating and so intellectually dishonest, but that is their line.

I wanted to come back to the point you were making, the really great history that you laid out in our introduction, but as well, the material that Coates covers in his book. I really didn’t understand that some of private equity’s rise to power really was a function of lobbying. I didn’t understand that until it was laid out clearly for me in Coates’s book. I had always thought that these big private-equity firms were fairly hands-off in Washington until they had to be, and I didn’t realize that so many of the conditions that set the stage for their rise and for this transition from public markets to private markets has actually been fueled by lobbying money.

You’re exactly right. You can see that it’s both political parties in the so-called carried-interest law, which is the inability to tax a portion of the compensation that private-equity funds get at the normal rate rather than the capital-gains rate.

Democrats have refused to do anything about it, too, and that’s because this is one of private equity’s sticking points, and you can see how much political power they have in both parties by the failure of that to get through the Democratic Party. I mean, it’s somewhat insane when you pause to think about it, and it’s really upsetting. Right now, Senators Grassley and Whitehouse have announced this bipartisan investigation into the role of private equity in healthcare, and if anybody in Washington hears this, please make it real, please make it real.

What I’m worried about is that the behind-the-scenes lobbying is going to mean that this is one of many congressional investigations that gets announced to a lot of fanfare and then just quietly goes away, because the political donations will mean that it’s just not in anybody’s interest to pursue this, even though it’s incredibly important.

Luigi: On the point of the evolution of private equity, let me try, because several years ago, I looked into this topic, and actually, I had some proposals to try to deal with this explosion of private equity. Some of the arguments that the lobbying industry made were legitimate in the following sense: why do we have regulation of public markets? We have regulation because there are a lot of unsophisticated people who play in the public markets, and we need to protect them from abuse for two reasons. Number one, we don’t want them to be hurt, but number two, if we don’t have a cop that protects them from being hurt, they will be reluctant to participate, and that makes the market less liquid, so everything looks great.

Now, if you are Warren Buffett, you don’t really need the protection of securities regulation, and so, this is the area where they started to put the camel’s nose under the tent and say, “We can make an exception for the more sophisticated people.”

I think it’s not a crazy idea to have that exception. The problem is that once you start, then the exception became greater and greater, and slowly, there was an erosion of public markets because there is a huge differential cost. The fact that public markets have a lot of disclosure requirements makes firms more reluctant to go to the public markets.

And so, my proposal several years ago was, we need to reduce this gap, but not reduce it in the way most people say, that is, only by cutting regulation in the public market. We should increase regulation in the private markets so that the difference is less severe. Of course, nobody paid attention to what I said, but it’s important to understand that there is a huge gap, and I think that this gap is not healthy.

Bethany: Yeah, I could not agree with you more. See, we start on a topic on which we don’t agree, and we come to this kumbaya moment of complete and total agreement. I really like your proposal.

I like my proposal, too, which is just to take everything that supposedly is private and say, “OK, same regulations, same transparency requirements, then now, see how you like it.” That would be very satisfying to me.

That whole sophisticated investor thing is another smokescreen, I think, that private equity hides behind. Everybody knows that many of the pension funds that invest in big private-equity firms or big hedge funds or big venture-capital firms are not sophisticated investors. They’re not.

Everybody understands the game that is getting played by which these big pension funds want to be able to report to their bosses a lack of volatility. Private-market investments, because they aren’t reported publicly, everybody gets to pretend that the loss didn’t happen and hope that the next year makes it up. It’s return-smoothing, and everybody gets to pretend that the loss isn’t real in a way you don’t if everything is public, and it’s marked to a public market. It’s all the lack of honesty around it, the failure to just say what it is and call it as it is, that really bothers me.

Luigi: It’s a lack of honesty, it’s a lack of transparency, and in this, Coates is right. Even the amount of lobbying, if the industry was more transparent, would be more visible. It probably would be more limited.

When it comes to index funds, I like the idea of pass-through voting, that is, the fact that they send their votes to the ultimate investors. Now, this is very easy to do with institutions. It’s a little bit more complicated with individuals because most individuals don’t participate. They hardly participate in presidential elections every four years, let alone vote for 500 companies every year. That would be crazy.

But I think there are two very simple solutions. One, is a solution of creating some guidelines like, “We don’t vote for all the legislation that gets passed through Congress, but we have a party that we appoint that does that.” You could have different guidelines for the parties, for the funds, and they follow those guidelines. And then, you pick the guidelines when you buy your Vanguard S&P 500 fund. I want to vote like X or I want to vote like Y, and automatically, they vote in that direction. That could be one idea.

The other is actually an idea that I’m developing with Hélène Landemore. You remember when she came to the podcast, and it actually emerged from that podcast and with Oliver Hart. It is to say, why don’t we try to use the citizen assemblies—in this case, investor assemblies—to give some guidelines?

Imagine you randomly draw a hundred investors from Vanguard, and then, you give them a minor stipend and a little bit of information to decide how Vanguard should vote on major issues. Because they are randomly drawn, they’re representative, and because you are one out of a hundred, probably it feels worthwhile for you to spend the time. You do it for a year, and then next year, somebody else will be elected. In this way, you have a form of a democratic representation, but not too costly for investors.

Bethany: I did think that it was encouraging that Coates did say that private-equity firms, index funds, do acknowledge privately that they have a problem, given the power they exert in the halls of Congress. There has to be some enormous amount of public pressure coming, not just political pressure, and they have to be willing to make the changes, or the changes probably won’t happen.

Luigi: I think you’re more optimistic than I am, because when—

Bethany: I’m trying, I’m trying.

Luigi: —when rich people in a private room say something to John Coates, I think they’re trying to save their intellectual status by saying the right thing. When they move next to Washington, they do the opposite, because it’s in their interest. If they really believe that, you say it publicly, and if you only say it privately, then you’re either a coward or a hypocrite.

Bethany: Geez, Luigi, that might be the most cynical thing I’ve heard you say yet. But you might be right. I guess the only caveat or the only counterargument is that everything is negotiating leverage, and if they admit publicly that they know they have a problem, they concede a really important point off the bat.

But as I talk about this, I realize this might be something I need to dig into in Washington and start figuring out how real the problem is. Well, we know the problem is real, but how likely it is that anything changes, because that would be a really interesting question.

Luigi: You have your new book, Bethany, Private Equity in Washington.

Bethany: Right? Maybe.

Luigi: Instead of Mr. Smith—

Bethany: I mean—

Luigi: —goes to Washington, you have what? Mr. Private Equity goes to—

Bethany: I mean, Mr. Private Equity, exactly.