The flavors du jour in the financial realm are index funds and private equity funds. They both come from a tiny handful of gigantic investment firms, but their frameworks are very different. Their effect on the economy, however can be devastating. John Coates examines them in The Problem of 12, from Columbia Global Reports, my favorite book series, for years now. These short-ish books pack a wallop of information from deep research and/or direct experience, making sense of the lies, half-truths, and simple lack of understanding. They are pretty much all outstanding. This one is no exception.

Index funds simply replicate an index, such as the S&P 500 or one of the Russell indexes (Yes, I’m going to use indexes instead of indices). The investment firm buys the same stocks the index tracks. The index tracking shares then rise and fall in lockstep with the index itself. Since major indexes are rigged to go higher forever, investors should benefit. And they do. It’s typically easier, safer and more profitable than individual stock picking and portfolio management. The investment managers benefit because they don’t have to actively manage the index fund, and risk underperforming. There are no decisions, no evaluations, no choices. It is as close to transparent as can be. Fees are therefore low, and net returns to shareholders are relatively high.

Private equity funds take pools of money from shareholders and buy up companies with it. They typically manage them into bankruptcy, having bled them dry, after making it impossible for them to succeed, or even survive. Where the index fund is a fully regulated investment, private equity seeks to circumvent all regulation by managing a private firm (even if they have to take it private themselves), where none of the business of the target firm need be reported publicly. None of the disclosures of a public security apply to private equity investments. So investors get no information. The fund managers get to play in total secrecy, awarding themselves massive fees and reducing headcounts and assets at will. So although the publicly traded private equity funds don’t do spectacularly, the management company always wins big. And early.

Where this becomes a problem is in scale. A tiny clutch of immense fund managers – Blackstone, State Street, Vanguard, Fidelity, Goldman Sachs – totally dominate index funds. The first three alone control 20% of the votes of the S&P 500. For every index fund share they sell, they get to vote in annual and special meetings – not the retail investor, but the fund manager. The managers have the power to stack boards, change policies, set rules for compensation, pick auditors, and so on. They are making over the whole world in their image. This was never the goal of free markets or securities legislation. And nothing is being done to rein it in. It is as if the chairman of Blackstone, the world’s largest fund manager, can run the world as he alone sees fit, using other people’s money.

The book details all the weaknesses and faults of these two types of funds, which are new to the market. Laws haven’t even tried to catch up. Trillions of dollars are being made at the expense of labor and vendors, as private equity strips out any and everything that has value, before walking away from a bankrupt shell.

At the rate these funds are growing, Coates says, the actual majority of shares of the top 1000 public companies could be controlled by just a dozen fund managers, and that is within the next 20 years. This is clearly a tectonic shift, worth noting not just by readers but by the SEC.

And that is just index funds. Here is what Coates says about private equity funds: Private equity funds “are doing as much if not more than index funds to erode the legitimacy and accountability of American capitalism.” They do this buying up whole companies, taking them private and removing them from the market and oversight. To date, private equity has 12 trillion dollars’ worth of formerly productive business under management. They assemble target firms into cartels (and get fined for it – at least in Europe) – and in general act totally without regard to anyone or anything else, be it layoffs or colluding with fellow fund managers, supposedly their competition.

Coates points out that the USA is the right target for these buyouts and dismantlings, because its laws are so lax. Workers there “have weak legal entitlements (the weakest of all countries assessed by the Organization for Economic Co-operation and Development), including underpriced unemployment insurance, and are no longer meaningfully protected by labor law or unions. Labor and taxpayers, who subsidize some of the costs of job loss, are generally likely to lose from greater private equity dominance of the economy.” And “They are tax-favored in ways that are hard to defend” as they remove an industry or a store at the center of life in a community. And just to add a dash of slime, they fight off reporting their political campaign contributions and influence, again because they are private, even if the strings are being pulled at a public company.

Coates is the perfect person to write it all up. Far from the eager journalistic digger so many of these kinds of books bring out, Coates is a lawyer who has lived the financial markets his entire career. To quote the back cover, Coates is “the John F. Cogan Professor of Law and Economics and Deputy Dean for Finance and Strategic Initiatives at Harvard Law School ... He was a partner at Wachtell, Lipton, Rosen & Katz, specializing in financial institutions and M&A.” He consults for the Department of Treasury and Justice, and the NYSE. His writing style shows he is totally comfortable and at ease in his subject, and he tries his damnedest to be evenhanded. Sometimes laughably, when it comes to the insanity of private equity funds.

A couple of things surprised me by their absence. Coates describes how these same fund managers are busy milking the new fad of ESG (which used to be called corporate responsibility). People now actually invest their money because of high ESG ratings in addition to or even instead of good business results. But Coates does not mention that his usual suspect fund managers never bothered to craft an actual ESG fund. Instead they renamed existing funds as ESG, or mirrored an existing fund and dropped or added a company to make it appear they had customized an ESG fund. The result has been billions in new money flowing into the same old funds. It is an ordinary, garden variety Wall St scam with a huge number of zeroes after it, and that should be a problem for regulation. But it isn’t.

And then sometimes, Coates is just too fair. The truth about private equity is that it rapes and pillages working firms. As part of their takeover deal, the target company must issue a massive amount of new debt, essentially paying for itself with its own money. The private equity firm gets away with putting up a few million of its own funds, so that not only is there little or no risk to them, but its return on actual investment is gigantic. They win before they even start. When it comes time to pay the investors, suddenly, there is very little money to disburse.

It reminds me of Hollywood in its golden age. Huge blockbuster films would claim to be money losers when it came time to pay those whose contracts said they would get a percentage of the profits. The studios simply expensed everything at whatever amount they felt like, leaving the books to show red at the bottom. So with private equity.

I have seen this numerous times, and it is entirely predictable. They buy an established company, load it down with debt, pay themselves back almost immediately, lay off workers until the firm can’t function properly, sell off the assets one by one to keep the dividends flowing from the proceeds, and put the unsellable shards into bankruptcy. And on to the next deal. As Coates acknowledges at several points in his book, private equity “might not be of any benefit to the economy.”

He is far too polite.

David Wineberg ( )