The Power Of Diversity, Equity, And Inclusion To Improve Risk-Adjusted Returns In Private Equity

Assets managed by diverse-owned firms have only increased by a tenth of a percentage point to 1.4% of the $82.2 trillion US asset management industry since 2011 despite extensive investor commitments to increase the diversity of their investment portfolios. Clear research on the performance, risk and financial diversification benefits of diverse managers is necessary for further progress.

Accordingly, last month, Institutional Allocators for Diversity Equity and Inclusion (IADEI), a consortium of over 500 asset owners seeking to drive diversity, equity, and inclusion in asset management, launched its research library and presented the results of its private equity diversity literature review. The library is now one of the largest open-source collections of research on the impact of diversity, equity, and inclusion (DEI) on asset management. Private equity (venture capital, growth equity, and buyout) performance is of particular interest in part because private equity outperformed private debt, real estate, natural resources, and infrastructure over both the past year and the past ten years.

IADEI finds that DEI has the potential to improve performance and reduce risk in private equity portfolios. At the same time, more rigorous research and research covering more dimensions of diversity are critical. Furthermore, most of the diversity research focuses on venture capital, and gauging the impact of diversity on other strategies is important.

DEI and Investment Performance

Results. Diversity is correlated with stronger risk-adjusted performance. To illustrate, Gompers et al., 2019 found from 1990 to 2018, that a 10% increase in diversity in venture capital is correlated with a ~1.5% increase in internal rate of return (IRR). Among buyout funds, investment teams with at least one woman are associated with 12% greater IRR and 0.52x higher total value paid in (TVPI) than all-male teams (Gottschlag, 2019). TVPI is the ratio of the current value of remaining investments within a fund plus the total value of all distributions to date relative to the total amount of capital paid into the fund to date: generally higher IRRs and TVPIs are indicative of better investments. An IFC study found that venture capital-backed companies in emerging markets with gender balanced leadership teams had a 1.6 times increase in their step-up valuation, or change in valuation between rounds of financing. The step-up valuation for gender balanced teams is 5% higher than leadership teams with 10-30% women, and 13% higher than leadership teams with less than 10% women. (von Friedeburg et al., 2019). By way of background, buyout funds use leverage to purchase majority stakes in more mature businesses, while venture capital funds tend to make minority investments in startups and small businesses.

Causality concepts. Diverse teams may improve decision-making due to diverse perspectives, skills, and abilities (Hammer et. al., 2020). In addition, diverse team members may have differentiated networks if there is homophily in networking, where individuals may feel more comfortable networking with others of the same backgrounds (Howell et. al., 2019).

Critiques and key questions. Research on buyouts shows a tradeoff between improved decision-making due to a broader set of perspectives and deteriorated decision-making due to a potential for clashes and lack of cooperation among teams, but the benefits of diversity have been shown, in some cases, to be more important (Hammer et. al., 2020). Research suggests that greater gender, age and nationality diversity is associated with higher buyout returns and multiple expansions, but the opposite is true for more diverse professional experience, educational background, and university affiliation. The results of other studies do not support the business case for board gender diversity, which suggests that diversity is not associated with an increase in performance. Instead, these studies allow the conclusion that board gender diversity should be promoted for ethical reasons to promote fairness: if a larger representation of female directors does not matter with regard to firm performance, females, if equally qualified, should be given priority when promotion decisions are made (Pletzer et al., 2019).

DEI and Risk

Results. Diversity is associated with improved risk management. In particular, diversity is associated with a higher likelihood of deal closure in mergers and acquisitions (Ravaonorohanta, 2020). In addition, there is statistically significant evidence that fund-level investment performance is negatively correlated with sexually predatory and/or discriminatory behavior (Smith, et al., 2018), and gender-diverse boards tend to implement more persistent and less risky financial policies (Bernile, et al., 2018).

Critiques and key questions. Although team heterogeneity has an overall positive effect on market share and profits, it can also be a double-edged sword in that diverse management teams may be slower in their actions and responses and less likely to respond to competitors’ initiatives (Hambrick et al., 1996).

Similarly, research shows that board diversity is not equally effective in all circumstances. First, its moderating effect on firm risk increases with the firm’s R&D intensity and growth opportunities, consistent with the larger benefits from diversity when the firm profile is fundamentally riskier. Second, the moderating effect of board diversity on firm risk decreases in more volatile conditions, when a nimbler decision process and swifter reactions may be more beneficial (Bernile et al., 2018).

Calling All Academics to Refine Methodology and Broaden Span of Research

On the surface, a clear consensus in support of DEI emerged from IADEI’s literature review of 146 papers on private equity—with 115 papers supporting DEI, 4 opposing it, and 21 inconclusive. However, more rigorous research examining a broader range of dimensions of diversity across a broader range of private equity sub-asset classes is required to better establish correlation between DEI and risk-adjusted returns.

Quality of research. Of the 146 papers reviewed, only 19 or 13% differentiated themselves with the following characteristics: direct analysis of PE performance or analysis of DEI on a portfolio company level; quantitative analysis with a clear, rigorous, and objective methodology; well-known and reputable authors and institutions; and robust and high-quality data with actionable insight.

The remaining 127 papers included a range of methodological issues. Some authors seemed to assume that DEI was beneficial before analyzing performance or risk. In addition, many papers did not include a clear or quantitative methodology in their analysis, struggled to quantify diversity, or focused on relating indirect characteristics—like board composition and M&A premium—to private equity or firm performance. Also, some papers relied on algorithms to categorize race, focused on old reports, or did not control for common variables like firm size, market returns, and geography.

Span of research. Papers generally focused on gender diversity in venture capital, and there was very little research on other forms of diversity or other sub-asset classes.

Accordingly, IADEI is calling academics to research the impact of racial, ethnic, and cultural diversity on private equity returns and the impact of multiple facets of diversity on buyout and growth equity as well as other asset classes beyond venture capital.

Institutional investors would also benefit from clear research on the financial diversification benefits of diverse managers. Material market inefficiencies stem from perceived racial, gender, and geographic biases and access to underserved markets. Research on whether diverse managers are more likely to invest in underserved communities and whether that enhances overall portfolio diversification would be valuable.

At the same time that more research is needed to achieve clarity on these issues, W.K. Kellogg Foundation Director of Investments and IADEI Steering Committee Member Reginald Sanders reflects: “When someone is a champion of DEI, the burden of proof is often on the champion when it really should be on the skeptic of DEI. Not only is diversification the only free lunch in finance, the benefits of diversity are a universal first principle that applies to all walks of life. Therefore, the responsibility rests with the DEI skeptic, not the champion, as to why an exception has to be made when the diversity conversation pivots to race and gender.”

Calling All Institutional Investors

IADEI also invites institutional investors and diversity experts to contribute research spanning asset classes on the relationship between DEI and performance and welcomes leadership in analyzing other asset classes.

By pooling intellectual resources, IADEI and other like-minded organizations may be able to make the business case for driving diversity, equity, and inclusion within institutional investment teams and portfolios and growing the percentage of assets managed by diverse-owned firms far beyond 1.4% in the ten years ahead.

This article is based on research of Institutional Allocators for Diversity Equity and Inclusion (IADEI), Cornell Senior Investment Officer Roger Vincent and Analyst Nathan Nangia and their colleagues from the Cornell Investment Office.