Three ways to advance diversity, racial equity and inclusion through investing

Investor capital can advance DE&I by targeting three stages of the investment value chain, writes Stephanie Kater, a partner at The Bridgespan Group.

With racial equity at the top of the US social justice agenda since 2020, more private-market investors have become interested in using their investments to advance diversity, racial equity, and inclusion (DE&I). These impact investors have made explicit commitments – and in some cases have actually begun – to invest in existing racial-equity-focused funds.

While The Bridgespan Group has seen significant interest in this topic, we’ve yet to see that interest translate into action at scale, perhaps because private-market investors in general – including philanthropists, high-net-worth individuals and fund managers – lack deep experience with strategies for achieving DE&I outcomes. Fortunately, there are a few frameworks and tools they can use, and these investors can have far more impact than they might realise.

One framework that caught our attention is provided by Mission Investors Exchange. Its approach to “disrupting unjust flows of capital” proposes three questions for examining investment strategy, allocation of capital, and results with regard to DE&I goals:

  • Who shapes investment strategy?
  • Who receives investment capital?
  • Who is affected?

These questions focus attention on critical points where capital changes hands and – crucially – how this affects people and communities of colour. In this article, I discuss why these questions are important and share examples of actions they have inspired investors to take.

Who shapes investment strategy?

Who shapes investment strategy has critical implications. At the investment-team level, the question becomes: “How much do these teams represent the communities their investments serve?” A McKinsey & Company study has found that racial diversity among professional staff in North American private equity firms decreases with rank – in 2020, for example, US investment deal teams were only 1-2 percent Black, even though the Black population is 12 percent of the nation. As a result, investment decisions in private equity too often rest with individuals who may not be representative of the communities those investments will affect.

At the portfolio-company level, the question becomes: “How much do leadership teams represent the interests of employees and beneficiaries?” Private equity investors have an outsized ability to influence the composition of boards and management teams in portfolio companies, especially in majority-stake direct investments. Racially diverse boards, in turn, are more likely to prioritise diversity within a company. Research has also found a correlation between a diverse board and improvements in financial performance and company governance.

In response to growing awareness of these issues, some private-market investors are thinking critically about representation in decision making and incorporating mechanisms for accountability to diversity goals at the team and portfolio-company level. Some examples of steps they are taking:

Making investment firms more diverse. At Ariel Investments – the first Black-owned mutual fund firm in the United States – 38 percent of leadership (VP and above) are people of colour, 22 percent of them Black. Fifty percent of board members are Black. Vista Equity Partners, the largest Black-owned private equity firm globally, is building a pipeline of diverse talent: within the firm, 50 percent of employees are women, 35 percent are people of colour, and 15 percent are from other underrepresented groups.

Making explicit commitments to creating accountability on DE&I. TPG, KKR, and Palladium Equity Partners, all ILPA Diversity In Action signatories, have made a commitment to advance DE&I in the private equity industry by publicly communicating a strategy that addresses tracking statistics on hiring and promotion by gender, race and ethnicity; creating organisational goals for inclusive recruitment and retention; and making DE&I demographic data available to investors or investees during fundraising. In addition, signatories can opt in to tracking DE&I statistics within portfolio companies.

Who receives investment capital?

Racial disparities in asset management are stark. Firms owned by women or people of colour manage only 1.4 percent of total AUM – even though there are no statistically significant differences in performance between such firms and their white- and/or male-owned counterparts.

The same disparities are present in the universe of investee companies. Black-founded start-ups, for example, raised only 1.2 percent of overall VC funding in the first half of 2022. Data released in 2020 by the Federal Reserve, meanwhile, showed that Black-owned businesses are twice as likely to be turned down for loans as white-owned businesses, and less than 47 percent of their bank financing applications were fully funded.

When it comes to the workers companies employ, not only are Black and Latinx employees paid less due to racial wage gaps, they’re also less likely to work for employers that offer retirement benefits – an important factor behind the sizeable racial wealth gap in the United States.

To help remedy these injustices, some investors are deploying capital to funds and companies in which leaders and employees come from historically underrepresented, marginalised identities, including communities of colour. Here’s a sampling of the approaches they’re taking to these efforts.

Investing in companies founded and led by people of colour

  • BlackRock’s Impact Opportunities Fund has targeted $1 billion to “invest in businesses and projects owned, led by, or serving people of colour, with a particular focus on Black, Latinx and Native American communities”. An example of such a business is BRP Companies, a Black-owned and -operated real estate firm with which BlackRock partnered to invest in a 292-unit multifamily rental community on Long Island.
  • Apis & Heritage Capital Partners is a Black-led private equity fund. Its Legacy Fund I (which recently closed oversubscribed on $58.1 million) uses an “employee-led buyout” model to convert companies “with substantial Black and brown workforces into 100 percent employee-owned businesses”. The fund intends to buy at least eight businesses – converting more than 500 workers into employee-owners in the next five years and enabling each to accrue $70,000–$120,000 in retirement savings.

Funding managers of colour

  • As part of the Ford Foundation’s Mission Investments strategy, as of September 2020, $99 million of Ford’s $191 million in mission-related investments had been placed with managers who are female or people of colour.
  • Because the financial industry’s existing approach to financial due diligence creates barriers for asset managers who are Black, Indigenous, or people of colour, the signatories to the Due Diligence 2.0 commitment seek to rethink track record and AUM as the major criteria limited partners use to assess general partners for capital allocation.
  • The Expanding Black Business Credit network’s Black Vision Fund will make loans to six community development financial institutions with track records of expanding financing for Black-owned small businesses.

Who is affected?

This question focuses attention on differential outcomes by race across areas such as housing, healthcare, criminal justice, education, economic mobility and the environment. For example, in public health, low-income people and communities of colour are more likely than white communities to live near coal plants or other toxic sites or breathe polluted air. Homeowners in majority-Black and -Hispanic neighbourhoods (using US Census Bureau designations) are also less likely to have rooftop solar installed. In education, the Covid-19 pandemic has likely reversed the gradual decline in racial achievement gaps in the United States.

Increasing awareness of such injustices is spurring some private market investors to deploy capital to increase the power, agency and wealth of people and communities of colour over the long term – for example, by investing in products and services that disproportionately or differentially benefit communities of colour:

  • Powerhouse Ventures has invested in Solstice, a software firm with a product that predicts prospective customers’ future utility-bill-payment behaviour to help expand solar access to low-income households (likely disproportionately people of colour).
  • BlackRock’s Impact Opportunities Fund, The Builders Fund and A Street have invested in Acelero, an early-childhood education provider focused on closing the achievement gap. Over 90% of the children in Acelero’s Head Start and Early Head Start programmes who participated in fall 2020 data collection – and showed significant educational gains as a result of participating in these programmes – identify as persons of colour.
  • Incubators such as Justice Capital and Common Future help launch initiatives for building power and influence in communities of colour. An example is the Common Future Accelerator, which invests in organisations that are developing models for closing the racial wealth gap.

As the examples cited above show, there are many ways to go about investing with a DE&I lens. There is also a range of meaningful outcomes for which investors can aim. While private market investors approach DE&I investing from differing vantage points, the spectrum of strategies and tactics illustrated above can help them choose the most suitable tools for where they are – keeping in mind that small steps can add up to meaningful impact over time.

Finally, no matter where they are with their DE&I investing, all investors are encouraged to consider the three questions explored here – who is shaping strategy, who is receiving the capital, and who will be affected – for both their investment policy and for every individual investment.

Stephanie Kater is a partner at The Bridgespan Group, based in Boston.