With COVID-19 tearing through national economies and exacerbating socioeconomic, gender, and racial inequities, global leaders need to continue prioritizing diversity and inclusiveness for the benefit of their culture — and their bottom line.
While PE firms and their portfolio companies don’t typically come to mind when thinking about the corporate leaders of the economy, the private market largely influences the status quo of the business community. With over 10,000 major PE firms holding $3.9 trillion in assets under management, these firms have the potential to majorly disrupt the role of diversity and inclusion (D&I) in organizations across the globe and have an immediate positive social impact.
The Case for D&I in Private Markets
The impact of D&I in public markets is clear: companies in the top quartile for gender diversity on executive teams are 25 percent more likely to have above-average profitability than companies in the fourth quartile. The case for ethnic diversity is even greater — top-quartile companies outperformed those in the fourth by 36 percent in profitability.
An internal analysis by the Carlyle Group, an American multinational private equity firm, showed that the average earnings growth of Carlyle portfolio companies with two or more diverse board members was nearly 12% greater per year than its average portfolio company over the past three years. Furthermore, after controlling for industry, fund, and vintage years, companies in their fund with diverse boards generated earnings growth that’s five times faster, on average, with each diverse board member associated with a 5% increase in annualized earnings growth.
Though it is still early to make a concrete proclamation for PE, the scale of potential value creation is extraordinary. Moreover, by applying this business case to private markets’ fund performance, not only would a given firm increase its likelihood of outperforming other funds, but it would also likely produce significant additional enterprise value.
In addition to monetary gains, there are other relevant and compelling reasons as to why private market managers should consider D&I in their portfolios. For example, thanks to various broader networks, diverse teams better enable investment firms to access exclusive opportunities, both when looking for unique deals and exceptional talent.
Moreover, a diverse team significantly influences decision-making, specifically how investment managers allocate their capital; deal flows generated by heterogeneous groups often invest in opportunities historically overlooked by private equity firms. These opportunities usually include businesses run by diverse entrepreneurs or teams that have two or more visible minorities. This not only suggests an increased potential for alpha generation but improved innovation and performance.
Private Equity Firms Lagging in D&I
Despite its undeniable influence, private equity firms are still falling short of implementing diversity and inclusion in the workforce. A 2021 study by the Boston Consulting Group found a 10-percentage-point gap between publicly traded companies and the PE sector, with only 55% of PE-backed firms having recently moved to address these issues.
Whatever the reasons are for the lack of focus on D&I in private markets, an absence of D&I initiatives can result in consequential costs to performance and the bottom line. Firms not doing enough to remove barriers and promote inclusive corporate cultures will be forced to spend additional time, money, and energy on reducing absenteeism and eventually hiring new staff to replace those who have moved on to more appealing positions.
A Call to Action: How PE Firms can Advance D&I
Make public commitments to internal and external D&I goals.
To ensure accountability, PE firms must show D&I progress to the broader public and all relevant stakeholders. Companies can do this by mandating yearly or quarterly diversity and inclusion reports, establishing internal D&I councils or executive committees, and developing metrics to monitor progress and compare results.
Conduct diversity assessments of prospective companies.
By building D&I criteria into the due diligence process, PE firms can not only assess the associated risk with a given company, but they can also wholly understand the additional value associated with a target’s investment.
Once targets are acquired, PE firms should then mandate D&I value creation, including but not limited to implementing D&I programs, training and tracking. Upon exit, D&I should be revisited as one of the value-creation levers.
Establish diversity at the management, executive, and board levels.
A smaller percentage of ethnic and visible minorities at the highest management level trickles down into fewer investments in diverse entrepreneurs and teams. Unfortunately, this uphill battle often results in fewer successful exits, which investors then use to justify denying funding, creating a vicious cycle of a lack of capital.
By ensuring diverse individuals occupy decision-making roles, institutional roadblocks and barriers presented to targets can be removed.
Click here to learn more about Diversio and our work setting the global standard for diversity and inclusion in private markets.