Why private-market investors need to accelerate their push for diversity

There is overwhelming evidence that private-market investors can do more for diversity, equity and inclusion. A recent report by McKinsey & Company showed that in 2020, 20% of senior leaders at US private equity firms were female (compared with 30% in corporate America). Even more strikingly, black executives made up less than 2% of investment teams, and other ethnic minorities only 12% – compared with a 23% share of ethnic minorities with relevant degrees in the total workforce.

This lack of diversity seems odd, given that investment firms understand the value of diverse (and often contrarian) thinking in making investment decisions. What is going on, and how can the industry change?

The framework devised by the author Matthew Syed is helpful. A box represents a problem to be solved (e.g., an investment decision, or transforming a portfolio company), and a circle represents the potential contribution by a team member, centered around the specific expertise of that team member and sized according to the depth of their expertise.

This graphic representation shows why diverse teams achieve better coverage of the problem (and are more likely to encourage better decision making) than homogenous teams – producing better outcomes, not just a “feel-good” factor.

How can the industry adapt so that investment firms routinely look more like the picture on the right and less like the picture on the left? I see three major avenues.

The most obvious solution is to broaden their talent intake – looking beyond traditional sources in the financial sector. At Brightstar Capital Partners, we partner with SEO Career to offer internships for college students from underrepresented communities. The industry must cultivate diverse talent the same way it cultivates business opportunities, by making sure it is nurturing a robust pipeline. However, junior talent will take many years to rise and join the executive ranks.

So firms needs to be more receptive to diverse lateral hiring at senior levels, including experienced operators from outside the industry. This will require an adjustment from the traditional view that every firm must run its own apprenticeship program and that the only way to partner or managing director is by completing this program.

Just as good athletes don’t make breakthrough progress without a team of coaches, simply appointing an internal DEI champion will limit the change that firms can effect. In 2019 my firm established a strategic partnership with Billie Jean King Enterprises (BJKE) for that exact reason. Through the partnership, we constantly challenge ourselves as individuals and as a firm to improve our understanding of DEI and to adjust our culture to be more diverse, equitable and inclusive. The key ingredient to this partnership is that we do not view BJKE as “outsiders” or “consultants,” but as “partners” - we give them access to all our employees and engage in frequent, unfiltered interactions. Without their perspective, knowledge and unfettered access, they could not be effective in helping us change.

I am very optimistic about how these and other steps can improve DEI in private markets,
and I see much encouraging momentum among my peers. But I also want to point out two
important boundary conditions on the journey towards DEI. First, most private market firms are small (98% of private equity firms worldwide have fewer than 30 investment
professionals, according to PitchBook data). This means firm-level statistics operate on a very small sample size (in the case of my firm, a single senior appointment will swing statistics by 7 percentage points). So forced percentages and quotas will not be helpful at the firm level.

Second, private market investors have a clear remit from their Limited Partners – to generate sustainable returns on the funds they are entrusted with. This defines the “problem space” in the framework above, and any diversity effort needs to be aligned with this remit. We view DEI as essential to improving our ability to make better investments and produce better returns.

How private market firms view DEI is important far beyond their own offices – roughly 4,700 US private equity firms own nearly 20,000 companies with approximately 9 million employees. In addition, with their long-time horizon, private market investors can effect structural changes during their ownership.

They are well-positioned to do this in two major ways.

Private investors can rebuild their portfolio companies’ leadership teams in the C-suite and at board level, with DEI in mind. The same rationale applies as for private markets firms – to not avail themselves of the most diverse and qualified leadership is to roll the dice on sub-optimal decision making. This is particularly (though not exclusively) true for companies operating in the consumer-facing sectors, which require deep understanding of their customers, and therefore all relevant societal groups.

Private investors can ensure that portfolio companies have robust DEI programs. This cannot be about box-ticking, and in many cases will require partnerships with expert organizations just like I outlined. To do this well means creating a culture that attracts the best and most diverse talent – which is essential in today’s economy.

Leadership changes after just acquiring a company can be delicate and require discretion – getting the timing wrong can imperil value creation and even the future of the company. Therefore, diversity measurement approaches that give a two-year window for change from the date of acquisition are more reflective of real-life situations than those demanding immediate change, no matter how well intended

It is crystal clear to me that making good investment decisions in today’s world means building the best teams, and to construct those teams requires diversity, equity and inclusion. Private market investors can and will be catalysts – making it happen for their own organizations, but also acting as multipliers of this approach into the wider economy where roughly 5% of GDP is linked to their investments. The simple steps outlined here, many of which are echoed by my peers, contribute to the much-needed momentum toward enabling an economy that is both more inclusive and more productive.