Pillar Two Of The Path To Inclusive Capitalism: Source Diverse Talent

This is the fourth article in a series on building diverse and inclusive institutional investment portfolios. The series draws from a guide for asset owners that Blair Smith and Troy Duffie of Milken Institute and I co-authored with input from the Milken Institute’s DEI in Asset Management Executive Council, Institutional Allocators for Diversity Equity and Inclusion and its cousin organizations, including Intentional Endowments Network, Diverse Asset Managers’ Initiative, National Association of Investment Companies, Association of Asian American Investment Managers, and IDiF.

This article focuses on the second of four pillars on the path to inclusive capitalism: sourcing diverse talent.

As McPherson, Smith-Lovin, and Cook noted in 2001, similarity breeds connection. This principle of homophily structures network ties of every type, including marriage, friendship, work, advice, support, information transfer, exchange, co-membership, and other types of relationships. The result is that people’s personal networks are homogeneous in terms of many sociodemographic, behavioral, and intrapersonal characteristics. Homophily limits people’s social worlds in a way that has powerful implications for the information they receive, the attitudes they form, and the interactions they experience. Homophily in race and ethnicity creates the strongest divides in our personal environments, with age, religion, education, occupation, and gender following in that order.

Let’s examine homophily and practical and evidence-based strategies to overcome its negative effects on three levels: individual investment professionals, investment firms, and portfolio companies.

Strategy 9: Build Diverse Investment Teams

The Kresge Foundation improves decision-making by purposefully building a more diverse and inclusive team. In 2019, the Kresge Investment Office launched a formal three-pronged commitment to DEI: people, process, and pulpit. Specifically, Kresge aims to expand its talent pipeline to create a more diverse and inclusive team, purposely seek out the best diverse-owned firms across all asset classes, and intentionally champion DEI initiatives within the investment industry. At the onset of the initiative, the Kresge investment team was approximately 71% male and 93% White. Today, the team is 46% male and 69% White.

EY research notes that hedge funds and private equity firms have been male-dominated since their formation by White men with investment banking or consulting backgrounds about 35 years ago. The inclination to recruit peers has resulted in a homogeneous workforce. According to the 2021 Preqin Impact Report, only 20.3% of employees and 12.2% of senior staff in alternative investing are female. Because no more than 31.5% of junior staff are female, gender parity is only achievable by sourcing talent from outside the industry.

Private equity and asset management firms have traditionally sourced their talent from premier investment banking programs and consulting firms. Although these institutions are increasingly focused on recruiting and retaining diverse talent, it will take time for them to reflect greater diversity. In the interim, widening the funnel, considering a broader range of backgrounds and experience for investing roles, and mitigating bias in the screening process will increase diversity.

According to a report in Harvard Business Review, if only one woman is in a pool of three finalists, there is statistically no chance she will be hired. When two minorities or women are in the candidate pool a woman or minority becomes the favored candidate. Some asset managers modify job postings to attract a more diverse set of candidates or request that recruiters source diverse candidate slates. Others remove candidate names and even candidate schools from resumés prior to screening. Further, others conduct blind first-round interviews or ask a diverse set of colleagues to screen candidates.

Strategy 10: Source Diverse Investment Firms

Some asset owners set minimum diversity thresholds for manager searches in consultant contracts. Although progress is slow, widening of funnels at the consultant level is already contributing to more diverse investment portfolios. In particular, Cambridge Associates committed in 2020 to double the number of diverse-owned managers and the percentage of assets under management (AUM) invested in those managers by 2025, as Carolina Gomez, the company’s director of strategy for diverse manager research, observed at a private investment conference sponsored by IADEI. Asset owners, in turn, can propel increasing diversity in consultant funnels by setting diversity goals.

Comparing notes with a broader range of peers and using nontraditional channels are critical approaches to sourcing diverse-owned companies and diverse-led managers. The hard work of industry participants and the DEI ecosystem to develop open-sourced diverse manager databases, and to host events connecting asset owners with diverse asset managers, has driven diversity efforts for decades. Performing diligence on and investing in diverse managers can create a snowball effect: It can catalyze greater diversity, as diverse asset managers refer other diverse asset managers to asset owners.

As shared previously, some investment teams are constrained from surveying the managers in their portfolio for diversity, and some risk management officers prohibit investment teams of state university endowments from incorporating non-financial factors, such as diversity, into investment processes, or even from identifying diverse managers during manager due diligence. On the other side of the coin, more progressive asset owners are reluctant to set diversity targets because they do not want to halt work on diversity once they achieve the target. In other words, they do not want the “floor” to become the “ceiling.”

Some asset owners mandate that every short list of managers include a diverse manager or explain why it does not. For example, Fairview Health Services requires the identification of at least one diverse-owned manager finalist in public equity and fixed-income manager searches, according to Investment Director Casey Plante. Likewise, the W.K. Kellogg Foundation sets a target minimum percentage of meetings with diverse managers across all asset classes, with the intention of achieving diverse manager exposure across asset classes, according to Managing Director Reginald Sanders.

In 2019, the Kresge Foundation pledged to invest 25% of its US assets under management in female- and diverse-owned firms by 2025. By January 2022, 16% of Kresge’s $4.2 billion portfolio was diverse-owned. According to Knight Foundation research, 100% of investment commitments made by Princeton University (managedby PRINCO) in 2021 were awarded to diverse-owned firms.

Strategy 11: Invest In Diverse Portfolio Companies

Results of studies show that homophily also affects portfolio company selection. Women fill 13.7% of senior roles in venture capital, only 10−15% of venture capital-based entrepreneurs are women, and from 1999 to 2013, less than 5% of all ventures receiving equity capital had women on their executive teams. The Diana Project found that many fundable women entrepreneurs had the requisite skills and experience to lead high-growth ventures. Nonetheless, women were consistently excluded from the networks of growth capital finance and appeared to lack the contacts needed to break through. Research suggests that providing women entrepreneurs with more exposure to venture capitalists may not be enough to eliminate the gender gap; instead, networking opportunities should be encouraged or even formalized, particularly in the realm of new venture competitions and accelerators.

Let’s Create A Hive Mind For Diverse, Equitable, and Inclusive Investment Value Chains

An open exchange of ideas about best practices for inclusive investing is critical to increasing the 1.4% of the US asset management industry that is controlled by women- and diverse-owned firms. Any best practices and lessons learned on sourcing diverse talent that you share can inform the work of Institutional Allocators for Diversity Equity and Inclusion and its cousins to drive DEI within institutional investment teams and portfolios and across the investment management industry.

The next article in this series will detail four practical and evidence-based strategies for equitable underwriting and provides examples of leading practices in implementing them.