Summary
- The financial industry has witnessed the dramatic rise of private equity and index funds over the last two decades.
- Now, just a handful of asset management institutions dominate American finance, as John Coates reveals on our recent podcast and in his new book, The Problem of Twelve.
- Political hostility to private equity and index funds is growing, but greater disclosure could appease policymakers.
The Rise of Index Funds and Private Equity
Jack Bogle became a Wall Street ‘laughingstock’ when started Vanguard in the 1970s. That is according to John Coates in our latest podcast. Yet it is now widely accepted that index funds offer investors diversified investments at low costs. Since 2000, index funds have managed assets at an annual growth rate of 12-20% and control a total of $12 trillion in US assets today.
Private Equity (PE), similarly, has soared in the last 25 years. In the 1980s, PE represented around 3-5% of the total capital formed and invested, but this has risen to 20% today.
Warren Buffet describes index trackers as making ‘the most sense practically’ for the average investor. And together, private equity and index funds have become the dominant institutional investors. However, their influence in the American health sector, voting power, and their limited transparency has generated political tensions in the US Houses of Congress. Coates describes private equity as a ‘completely dark part of the economy’, and it will likely need to emerge from these shadows soon to appease disgruntled policymakers.
Private Equity: Political Pushback Against Healthcare Engagements
In the early 2000s, following Enron and WorldCom’s bankruptcies, Congress passed the Sarbanes-Oxley Law. This increased the difficulty for companies to go public. From 1982-2002, the US created 7,000 new public companies, but only 3,000 have been formed since. Sarbanes-Oxley created an environment for private equity to thrive.
In this climate of opportunity, private equity has particularly focused on the US health care sector; PE has invested $750 billion in this industry in the past decade While Drew Maloney has argued that ‘private equity-backed hospitals earns better marks on quality’, Coates believes its immersion in health is ‘the most likely channel of political attack’.
In March, the Federal Trade Commission (FTC), DOJ Antitrust Division, and Department of Health and Human Services announced a new ‘cross-government public inquiry into private equity’, specifically regarding its ‘increasing control over health care’. FTC Chair Lina Khan argues that PE causes medical professionals to ‘subordinate their medical judgements to corporate decision-makers’.
The Center for Economic and Policy Research documents accusations that PE picks off profitable departments such as diagnostics, oncology, and ortho, converting them into outpatient centers. This undermines hospitals’ efforts to cover low margin essential services.
The inquiry also expressed concerns over private equity’s lack of transparency, referring to Coates’ focus on disclosure as the essential thorn between PE and policymakers. Pension Funds – the largest source of money for private equity – are taxpayer burdens.
As such, undisclosed investments of these finances are alarming the political players. Coates believes that the combination of tax breaks and healthcare encroachment, underscored by poor disclosure, is ensuring bipartisan hostility. Consequently, both Democrats and Republicans are seeking a minimum floor of risk/return disclosure.
The INDEX Act: Concerns Over Voting Power
Index funds have elicited similar political attacks in the US. In May 2022, Republican Senator Dan Sullivan introduced the INDEX Act with 12 co-sponsors. The act demanded passively managed funds to pass voting rights on to underlying investors. The threshold for this legislation would have allowed the state to target the major institutional investors such as BlackRock, Vanguard, and State Street.
Though it failed to pass, Coates stresses the awkward political situation index funds have found themselves; red states were upset with a 2021 climate resolution at Exxon, supported by BlackRock. Subsequently, certain red state governors have directed their state pensions to divest from BlackRock funds. Similar political-index fund interactions are occurring on the Democratic side of Congress.
The rapid growth of index funds has garnered bipartisan political attacks, with companies caught between the hammer and anvil of liberal and conservative investors demanding support on variable resolutions.
How Can These Institutions Appease Policymakers?
For many investors, it is essential that private equity and index funds continue to thrive. Lawrence Summers, former US Treasury Secretary, described the FTC’s inquiry as a ‘war on business’. Coates fears Vanguard and other companies will become caught up in a moment of ‘political reaction’.
Power attracts attention. When index funds take positions that certain political groupings dislike, it prompts interest. When private equity offers little transparency amid involvement in healthcare and public finances, it becomes a bipartisan eyebrow-raiser.
Coates adds that Market equilibrium is unlikely to be reached until these institutions control 50% of the votes of all listed companies. This indicates that their power will continue to grow, attracting intensified scrutiny. The question follows: how can private equity and index funds dissuade political operators of their concerns?
For private equity, Coates envisions a simple answer: ‘light disclosure’. Moderate transparency could ensure acquiescence from politicians without disrupting their business models.
For index funds, appeasement is ‘more complicated’, Coates continues. Disclosure is not the central issue, but variable positions. He argues that these institutions could reduce political hostility by opening themselves up to suggestions from their investors earlier in the cycle of a ‘given political issue’. At BlackRock they are attempting to achieve this through voting choice; they allow investors to pick a ‘family of policies’. This can be used to guide how they vote on certain resolutions.
Can These Institutions Survive Political Concerns?
Political hostility to private equity and index funds is not a new phenomenon. Legislation targeting their operations includes the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. While Coates believes further work is required to soothe policymakers and ensure public trust in these institutions, light disclosure and ‘soft consultation’ will likely be enough to protect these asset management institutions from disruptive political operations. Be sure to check out more on this topic by listening to our full podcast and reading Coates’ The Problem of Twelve.
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This article was written by Ranen McCormick as part of our internship program. It is based on an episode of Macro Hive Conversation, to which readers can refer for more information about the topics discussed.
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