John Coates: The Problem of Twelve, Index Funds and Private Equity.

0:00 -- Intro.

1:26-- About this podcast's sponsor: The American College of Governance Counsel.

2:13 -- Start of interview.

2:45 -- John's "origin story." His time at WLRK and at the SEC.

4:15 -- His focus at Harvard Law School and Harvard Business School.

4:39 -- About his book THE PROBLEM OF TWELVE: When a Few Financial Institutions Control Everything (2023). Publisher: Columbia Global Reports. 

"Around the year 2000 [Index Funds and Private Equity Funds] began a sustained takeoff and the book is motivated to tell the story of how that happened and then more importantly what's happened since 2000 with 10-15% compound annual growth every single year for both kinds of funds which is much bigger and much faster than the economy or the capital markets or corporations."

"The problem of twelve is just trying to get a catchy way to get people to understand that it's not just growth, that'd be one thing, but it's concentration."

11:22 -- On "What came before: the Twentieth Century's Public Company" and the rise of private markets.

"Actually, the public markets have gotten bigger, even though the number of companies has fallen. It's not like they're shrinking, which sometimes is the way people talk about it. But what's different is their autonomy is declining. So in 1990, the board of a public company and its CEO were the centers of power.  If anything, the CEO was probably the most dominant player and the board was kind of a check. The shareholders were kind of out there, but they really only mattered in a hostile takeover. That was it." "[By year] 2000, 2010, and definitely today what I just described is not true. Boards are now more powerful than CEOs in general. They have a greater influence over setting strategy today."

"[The] power started and ended with the CEO in the boardroom. And that really has, I think, dramatically declined and continues to decline as a way of describing how the US economic system works."

15:39 -- Evolution of US boardrooms since the 1970s.

"I think of boards as becoming more important during that period because businesses were stumbling. As long as CEOs were successful in running their empires, I don't think the pressure to provide a different governance system would have been nearly as powerful."

"Jay Lorsch at HBS wrote an early study suggesting that boards really were not doing much. Jay was very much part of the movement to get boards to be more active, because he thought that was better than the alternatives of either continued stagnation in economic activity or worse solutions, which other people were proposing."

20:19 -- On the impact and evolution of Index Funds.

"[T]he key thing is scale. It's not as if there's like 55 different index funds all competing with each other. No, there's really just a small number of families [ie. the Big Four, BlackRock, Vanguard, State Street and Fidelity] that are achieving these scale levels. So that's the basic problem of the book."

"[W]hen Jack Bogle set up Vanguard, he wasn't setting out to take over half of all the stocks in the country.  It took him 30 years just to get to 2%. It's just a side effect and so the system was not designed with that kind of concentration in mind. 

"[W]e're now having to go through a period where we've already started and it will continue for people as these things continue to grow and get even bigger to really rethink where should the governance power sit. Should it sit, at the board? Should it sit at the fund portfolio manager who doesn't really exist in an index fund, it's just a guy who has a list? Should it sit with a corporate governance professional that the fund advisor hires, that the fund then gives the power to? Or should it be something more complicated, some set of interactions between different people over time? And I tend to think that last thing I said is the right answer, but getting exactly the solution is hard, which is why I didn't call the book The Solution to the Problem at all, because I don't really have a perfect solution."

27:12 -- On the polarization of corporate governance and the ESG backlash.

"If it had not been climate, which is Larry Fink's, of course, major focus that generated most of the pushback, it would have been something else." 

"State Street a few years ago made a point of saying publicly that if the boards that they voted for were not sufficiently diverse and they had some specific criteria, they would withhold votes from the nominating committee chair. And you can see in the data, if you look at the way boards are formed, the impact of State Street's intervention."

30:35 -- On the pass-through voting initiatives.

"If you look at the websites that BlackRock and Vanguard and State Street all have up about what they're doing, they're not really passing the votes through or even getting close to it. They're going to let their own investors once a year pick a policy from a limited menu of policies, and then they're going to look how many people pick which policy, and then that will inform how they vote. So they're keeping the votes, but they are going to let people kind of give them an indication of more or less how to vote overall. And so that's some degree of trying to address the problem of twelve."

"I think in 10 or 15 years most people will do one of three things: 1) They'll let BlackRock keep voting the way they want to, with their money, and who cares? They're just not paying attention to governance, and that's their right. They can just ignore it; 2) a group of people will be pushing BlackRock to do even more of what they're doing now, to be even more green or left or however you want to think about it; and 3) there will be another group of people who'll be pulling the other way, and then BlackRock will probably be in there, be splitting their vote to some extent on some of the more high-profile issues."

On Exxon's proxy fight with Engine No.1.

37:28 -- On antitrust and concentration of power in index funds. 

"Antitrust traditionally would just look at the activity of investment as the right thing to think about concentration and not the governance impact. That's really not part of antitrust law. That's again part of why I wrote the book to get a different focus on this. [But] there are people who want to change antitrust law, they want to take concentration in governance and somehow relate it to portfolio company concentration." 

"There are claims for example that the index funds caused the airlines to be more collusive than they would be anyway. Or the banks or take your pick and maybe there's some truth to that but it's kind of indirect and I think it's going to take a lot of work to make that feel like you're being directly responsive to the problem and I'm not sure it'll get there in the end."

"There are also people who just want to change the basic understanding what antitrust is about, introduce politics into it again, and say this is a political problem and therefore we should use antitrust. There is a lot of resistance to that."

39:39 -- On the private equity industry.

"The biggest PE complexes not only have equity capital that they manage, they also have debt capital. And so in a difficult interest rate environment, that's a nice place to be. You have resources that you can tap on the credit side as well as on the investment side. And so I think, again, as with index funds, we're seeing greater concentration of greater growth driven by slightly different economies of scale, but I think still real, that allow the biggest players to sort of sit at the intersection of lots of different capital market activity. And that lets them leverage the information they gather across a much bigger base [and] grow faster than their competitors. I expect the big PE players are going to continue to do better than PE overall and better than the overall economy, even if they may run into some challenges in the next few years."

43:05 -- On PE driving ~25% of all M&A activity. "PE complexes in a lot of ways are sort of replacing a role that banks used to play, but without any of the regulation."

46:25 -- On the governance distinctions between PE-backed companies and public companies.

"[PE-backed boards are often] more focused and effective."

"[T]he PE world by design is with almost no public disclosure. There is disclosure sometimes of some things from the PE fund or advisor to LPs [but] the information flows [generally] are quite weak. And they're weakest in some respects around conflicts, which it should be the other way around. The conflict should be the place where the people with the equity at stake ought to be told the most and yet often that's the place where the system does not, in my opinion, live up to its billing. Part of the reason for that, it's not often appreciated that most of the money in PE funds comes from other funds, meaning, and in particular comes from pension funds who are overseen by well-meaning people, who often are honest and straightforward, but frankly are not up to, in my opinion, the task of overseeing a PE complex and their advisors. There's an industry association, the ILPA, that sort of tries to help coordinate across PE fund investors, the positions they take on disclosure and conflicts."

54:58 -- On SPACs.

"[T]here's a lot of companies right now that are going through some difficult governance challenges in the current economic environment in which the SPAC structure and the board that it brought in might be at odds with the sponsor or other people that were associated with the SPAC."

"If you're on a board or advising a board of a company that's associated with a SPAC, this is the time to really lean in about your conflicts, because the conflicts are absolutely really acute right now because of the interest rate environment."

*On SPAC Law and Myths (Feb 2022).

56:19 -- Books that have greatly influenced his life: 

1. City of Capital: Politics and Markets in the English Financial Revolution by Bruce Carruthers (1996)
2. Wolf Hall by Hillary Mantel (2009)
3. Mars Trilogy by Kim Stanley Robinson (1990s)

58:38 -- His mentors: 

1. Tom Noble (College advisor and History Professor)
2. Craig Wasserman (WLRK)

1:00:14 -- Quotes that he thinks of often or lives her life by: "Without contraries is no progression." [Poet William Blake]

1:00:43 -- An unusual habit or absurd thing that he loves: U.S. Soccer.

1:02:25 -- The living person he most admires: Tina Fey.

John Coates is the John F. Cogan, Jr. Professor of Law and Economics at Harvard Law School, where he also serves as Deputy Dean and Research Director of the Center on the Legal Profession. 

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This podcast is sponsored by the American College of Governance Counsel.

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Music/Soundtrack (found via Free Music Archive): Seeing The Future by Dexter Britain is licensed under a Attribution-Noncommercial-Share Alike 3.0 United States License