The racial justice protests that swept the country last year in the wake of the death of George Floyd at the hands of Minneapolis police spurred a widespread re-examination of the role of law enforcement in society and how it affects the day-to-day lives of African Americans – and a renewed focus on the racial disparities in every facet of American life.
In the private equity industry, that meant confronting a longstanding and deeply uncomfortable reality: just how few firms are owned or staffed by women and minorities, and the difficult road these managers face attempting to carve out a niche in an industry built on relationships and connections.
“People are saying… ‘see us, hear us, respect us,’” says Ron Parker, president and chief executive officer of the National Association of Securities Professionals, which serves as a resource for minority individuals in the investment industry.
For limited partners, many of which are public pensions, the pressure was especially palpable. As public institutions, they are answerable to their stakeholders. As one of the primary sources of private equity capital, they exert some influence on how the industry operates.
“They are the most powerful drivers of behavioral change in our industry,” says Carmen Ortiz-McGhee, executive vice-president of the National Association of Investment Companies, which helps woman and minority-owned private equity firms gain access to capital.
“When capital allocators speak, those deploying the capital listen,” says Paul Yett, the director of ESG & Sustainability at Hamilton Lane.
As 2021 gets underway, many US-based LPs are searching for ways to exercise that influence when it comes to what is often referred to as diversity, equity and inclusion, or DEI.
What is emerging is the need for action beyond corporate slogans and for clear and accurate measurement of what kind of progress firms are actually making – and a realization that things cannot go on as they have before.
The diversity and inclusion issues in private equity are clear, stark and widely understood in the field, but also seem intractable.
“It is dominated, I will admit, by people who look like me – pale, male and stale,” says Chris Ailman, chief investment officer of California State Teachers’ Retirement System, which at $275 billion in value as of November 30, 2020, is the second-largest pension in the nation, with $29 billion of that in private equity.
According to a 2019 study from the Knight Foundation and Bella Research, private equity firms owned by women or minorities made up about 9 percent of the funds created between 2006 and 2017 and less than 8 percent of assets under management. Women-owned firms accounted for 3.4 percent and minority-owned firms and 3.8 percent of total AUM.
Josh Lerner, a Harvard Business School professor who co-led the Knight Foundation research effort, says capital for black-owned firms is especially concentrated, with the top five largest firms controlling 88 percent of the AUM, according to an internal analysis. The above numbers for private equity were actually better than those of other asset classes, but still showed lots of work to do.
“The share of money across a wide variety of asset classes in the hands of diverse-owned firms was pretty modest,” Lerner says. “Private equity and venture capital has been no exception.”
Response to protests
After the protests struck, the second half of 2020 saw a wave of moves by LPs and industry organizations to meet the moment.
The uprising caught the attention of the Institutional Limited Partners Association, according to managing director of industry affairs Jennifer Choi.
In December, ILPA launched its Diversity in Action initiative, calling on firms and LPs to make concrete commitments, develop a public strategy, track internal hiring and provide demographic data for new commitments and fundraises.
Choi says many LPs are still formulating their response. “There’s an arc to this and we’re all in a different place in the journey,” she says.
Choi’s organization launched its initiative in early December with 46 founding signatories, including both GPs and LPs. By early January, that had increased to 65, with more than 40 in the works.
In November, Nilza Serrano, a member of the Los Angeles City Employees’ Retirement System board, closed out an investment committee meeting with some strong words for staff and consultants on giving opportunities to firms run by women of color.
“I’m not saying give them contracts, but ensure that they have an opportunity to sit at the table,” she said.
LACERS’ sister system, Los Angeles County Employees Retirement Association, heard a staff presentation on its own diversity and inclusion initiative at its December meeting. Board member Wayne Moore stressed the importance of setting concrete goals and making sure any beneficiary firms have African Americans on staff.
“The impetus for this whole discussion at LACERA and in the country has been driven by the racial discrimination and the exclusion of African Americans,” said Moore, who is black. “We don’t want to be excluded again from all these new initiatives.”
The same month, Teachers’ Retirement System of the State of Illinois increased the size of its emerging manager program and announced it was seeking out a “standardized measurement and evaluation tool” to keep track of the diversity of its managers, with an eye toward measuring firms’ entire workforces and not just leadership.
Leading by example
There are several LPs whose success in increasing diversity and inclusion can provide a model for others.
Public pensions are structured in different ways from state to state and are subject to different laws and regulations. This impacts how they make diversity a priority, but what tends to link them together is setting goals and then following through.
“It’s great to have an ideal, but great intentions don’t equal greater impact,” says NASP’s Parker.
Illinois State Board of Investment invests on behalf of several different statewide pension systems and has $25 billion in total assets under management, according to its website. The system has a successful private equity program. The most recent American Investment Council report on public pensions found it had the best 10-year PE returns as of June 30, 2019 out of 176 systems analyzed.
ISBI is required by state law to award at least 20 percent of state contracts to businesses owned by women, minorities or disabled people; 25 percent of the private equity portfolio is committed to diverse-owned firms.
“We’re very intentional about what we’re trying to accomplish,” says executive director and chief investment officer Johara Farhadieh.
The fund works with two consultants, Franklin Park and Hamilton Lane, to choose potential private equity partners. “In order for us to partner, they have to ensure that they can commit to our policies,” Farhadieh says. “Not only is it about the sectors they’re looking into, the types of managers – whether it’s buyouts, or growth, or venture – we also look into if the ownership is diverse or if the staff is diverse.”
Farhadieh says the formula for success is simple: “being intentional, having strong policies, strong leadership and holding yourselves accountable.” She also stresses the importance of a diverse staff and a broad and diverse sourcing network.
Connecticut Retirement Plans and Trust Funds invests for workers in one of the few “principal fiduciary” states, meaning that instead of being overseen by a board, the state’s investment program is overseen by the state treasurer.
Former treasurer Denise Nappier, who served from 1999 to 2019, made diversity a big priority, and that commitment has been carried on by her successor, Shawn Wooden.
Former chief investment officer Laurie Martin, who worked for the state from 2016 until last month, says the due diligence process for private equity commitments involve a questionnaire about a firm’s diversity statistics and efforts to improve, as well as a discussion between staff and the treasurer, followed by another between the treasurer and the GPs.
“I was kind of struck by the conversations we would have,” says Martin.
So far, Wooden has “doubled down” on Nappier’s efforts. The pension’s 20-year head start in tracking diversity and inclusion means it knows whether firms are making progress on diversity as they grow.
And while Wooden is still early in his tenure, he is not afraid to hold firms accountable, declining to commit to funds due to lack of progress on diversity. Martin says that has come as a surprise to some managers.
“I think they were expecting that it would just be a conversation, and it ended up with him saying… it’s not lip service, we feel really serious about this,” says Martin. “We’ve done that a few times.”
CalSTRS faces a different dilemma. State law says public entities “shall not discriminate against, or grant preferential treatment to, any individual or group on the basis of race, sex, color, ethnicity or national origin” when awarding contracts. “It’s something you have to navigate,” says Ailman.
For years, CalSTRS has used its “emerging manager” program, which directs capital toward new and smaller managers, as a way to “live within” the law, Ailman says. But over the last year, Ailman has been openly saying the pension is looking for diversity. That does not run counter to the law because a diverse range of opinions helps prevent the “groupthink” that can come when a firm all share the same background, so it is part of their fiduciary duty.
“We think a diverse group makes better decisions and particularly better investment decisions,” he says. “We think they consider risk better, and the downside better, and that leads to better outcomes.”
One of the greatest misconceptions around diversity and inclusion is the idea that committing to diverse managers connotes sacrificing performance for social good, Lerner says. He has found no statistically significant difference in performance between diverse firms and non-diverse firms when adjusted for vintage year and size groups.
Lerner and Bella also took part in another study in conjunction with the Association of Asian American Investment Managers, focusing on Asian and Pacific Islander-owned investment firms, including private equity funds. It also found no significant difference in performance.
“You’re not giving up returns by engaging with minority-owned firms,” says Jim Park, AAAIM’s chief executive officer.
Solange Brooks, a former CalSTRS private equity officer and chief executive officer of New America Alliance, a nonprofit representing Latino business interests, says that in the investment field, diversification is a critical tool that protects an investor’s portfolio through the ups and downs of the market – and diversity of people is another part of that.
“What makes you think that diversification of ideas, and diversification of people, and diversification of strategies is not just as important?” she asks.
“Let’s say everybody in your investment committee has the same background and are all best friends,” Ailman says. “To me, that would be a risk you would consider in your due diligence – that they have a huge blindspot, that they’re going to be unaware of something.”
Others say there is simply money to be made. “If you aren’t looking for diverse and woman-owned firms, then you’re just missing out on returns,” says Justin Wilson, director of the Diverse Asset Managers Initiative, which promotes diversity in the financial services industry.
NASP’s Parker stresses that what firms are looking for is partners, not benefactors. “None of these organizations are asking for a handout. These organizations just want to participate at the same level,” he says.
Another issue is scale. In an industry predicated on relationships, women and minority-run firms may have a tough time meeting LPs and accessing capital. Larger LPs must commit in amounts that are often as big or bigger than a new firm’s fund size, too, requiring some sort of emerging manager program or fund of funds manager to direct capital to new managers.
Organizations like NAIC, NASP and NAA work to link diverse managers with LPs and to educate about the opportunities available. Meketa Investment Group, an investment consultant that works on the private equity programs of both CalSTRS and California Public Employees’ Retirement System, the US’s largest pension, hosts twice-yearly events that connect diverse managers to LPs. (Last year, the two events were consolidated into one).
There are also a host of organizations like ILPA and the CFA Institute that provide guidelines for best practices on how LPs can improve their performance in this department. “I think getting involved is the number one thing,” Brooks says. “You learn by going out and talking to people.”
One theme that came up again and again was the lack of widely available data on diversity and inclusion, and how critical that will be toward really making a difference for the industry.
“I think tracking is really the first step,” says Brenda Chia, a director at Paladin Capital Group, and a founding board member and co-chair at AAAIM.
“It seems clear there’s need for an open-source kind of resource that would be more generally available and allow institutional and family investors to be able to identify diversely-owned funds,” Harvard’s Lerner says.
Tactics for change
Hamilton Lane’s Yett says having the information is an important part of the firm’s due diligence process. “It helps our understanding of a GP’s philosophy on equity and inclusion and whether or not the GP’s value system aligns with ours and with our clients,” he says.
Last year, former Muller & Monroe managing director Rendel Solomon told Buyouts he supported requiring private equity firms to supply their diversity statistics as part of the Form ADVs they are required to file with the Securities and Exchange Commission. “If you do that we can begin to truly see the depth of these issues,” he said.
“If you do it in a consistent, standardized way, then you can pull that data off the [Form] ADV and start tracking everything, and actually have everybody be on the same playing field, so that you can compare apples to apples,” Connecticut’s Martin says. “So that would be very helpful.”
Jason Lamin is founder and CEO of Lenox Park Solutions, a fintech firm that provides electronic spaces where financial professionals can connect to one another, one of which is for investment LPs. “This is a group of peers that is sharing where they’re investing, and sort of bringing all that into one database,” Lamin says.
Lenox Park has also created a proprietary measurement for diversity and inclusion in any organization, which can be applied to private equity. Subscribers as of January include the MacArthur Foundation, CalPERS, New York State Common Retirement Fund and Rhode Island State Treasury.
Lamin hopes this can become an industry standard. “I would say the quicker that the allocating community adopts one standard, the more progress we will see made in this space,” he says.
Meanwhile, Martin says Connecticut is drawing on its 20-year backlog of information to build its own internal database.
Many firms and consultants are hesitant to reveal their diversity statistics, though, which sources have ascribed to a fear of bad headlines. But the longer firms wait, the worse it could be. “Everybody’s numbers are bad. Nobody is doing this well,” says DAMI’s Wilson. “The people who are last are going to put themselves in the worst position for scrutiny.”
Parker stresses that nobody wants to play the “got you” game and shame firms for poor numbers. “This is not to be accusatory of what someone is not doing,” he says. “This is to celebrate what the opportunities could be when they do it.”
Another necessary step will be for LPs to “vote with their feet,” that is, be willing to withhold commitments if they do not see progress.
At LACERA’s meeting last December, Jose Fernandez of consultant StepStone Group said his firm had begun to see that happen, including one client walk away from a firm after investing in its previous eight funds.“We are starting to see consequences,” he said to the pension’s board. “I think that’s the role we can all play here together.”
The single biggest factor is realizing there is a problem. “We have to acknowledge that our industry has not done a very good job with respect to DEI,” Lenox Park’s Lamin says. “We want to encourage a tone of transparency and improvement.”
NAA’s Brooks calls public pensions “the people’s money,” stressing women and minorities are part of the people. “What you are saying is that minorities and women are good enough to put money in those pension funds, but they’re not good enough to manage them?” she asks. “Come on. That’s not right.”