5 Barriers Funders and Investors Must Break
By Tracy Gray & Emilie Cortes
How Foundations Fail Diverse Fund Managers and How to Fix It
Foundations and impact investors need to face the ways they are complicit in perpetuating inequality through their capital allocations, and upend five structural investment barriers to better serve women and people of color.
By Tracy Gray & Emilie Cortes | Dec 17, 2020
Originally published in the Stanford Social Innovation Review.
It’s time for foundations and other impact investors to face the truth. No more navel-gazing, no more conferring, no more research. Investors built the impact investing field to drive capital toward addressing climate change and social justice. But while the recent uprisings against racial injustice in the United States and elsewhere have forced all kinds of institutions into self-examination, most still fail to acknowledge and actively change the ways in which their investment strategies perpetuate inequality.
This is especially true of foundations whose assets globally exceed $1.5 trillion. Foundations are not only best positioned among all impact investors to provide catalytic capital (patient, risk-tolerant, or concessionary capital that helps attract additional investors to a project), but also have a fiduciary duty to invest in a way that aligns with their social mission and supports their grantees. The actual investment process, however—even at progressive foundations we’ve worked with that aim to eliminate gender and racial bias—continues to prop up the very structural inequities many of those grants are trying to erase.
Consider: Foundations have an internal investment team, governed by an investment committee, and are typically assisted by outside advisors who allocate capital to investment fund managers. The investment team’s goal usually is to earn more than 5 percent annually, maintaining or ideally growing the endowment—and the people in control are overwhelmingly white and male. Meanwhile, when the investment team does deploy investment capital to fund managers (who are, again, overwhelmingly white men), they almost always allocate it in a way that mirrors biases and inequities embedded in the mainstream investment process. There’s no question that these practices help maintain systemic racism and gender inequality.
This needs to change now. Here are five structural barriers that foundation investors and investment committees can easily upend today in their due diligence process to improve outcomes for people of color—especially underrepresented Black, Indigenous, and Latinx people—and women.
1. Dismantle the Risk Misconception
Mainstream investors generally consider funds led by people of color and women as higher risk, despite widely available evidence that diversity actually mitigates risk. For example, Goldman Sachs found that US funds run by all-women or mixed-gender teams outperformed all-male portfolio management teams by greater than 1 percent in the first eight months of a volatile 2020. And according to a report by Kauffman Fellows and Mac Venture Capital, ethnically diverse start-up teams outperform homogeneous teams and raise 60 percent more money than all-white teams in late-stage rounds. Also, the National Association of Investment Companies found that diverse private equity funds outperformed the median 62.5 percent of the time.
Meanwhile, where’s the research that shows that white men are less risky? If we look at the 2008 recession, the financial institutions requiring a bail-out were all run by white men. As Kristin Hull, founder and CEO of Nia Impact Capital, said to us, “When the Russell 3000 index dropped by 38.7 percent in 2008, no one questioned the white men managing it.” The fact is that investors don’t ask white men to present research demonstrating their performance, even in the face of catastrophic financial failures, yet they continually ask women and people of color to produce positive data about their performance.
One way to level the playing field for people of color and women is to make sure foundation investment managers and board members, chief investment officers, advisors, consultants, and all other impact investors know the data on fund performance and leadership diversity. They should include this research in the due diligence process (the “Due Diligence 2.0 Commitment” offers some guidance) and share it on the mainstage at conferences, not just at side sessions attended by those who least need to hear it.
2. Rethink Your Criteria
Foundations use seemingly concrete criteria to formally accept or reject an investment. Many foundations require that fund managers have a track record of investing with the same strategy at the same company stage. However, we know that very few diverse fund managers have been let into mainstream firms to acquire attributable track records. According to the U.S. Government Accountability Office, less than 1 percent of the more than $70 trillion assets in the United States are managed by people of color and women. Yet research by Pequin found that first-time fund managers actually outperformed established managers in every year except one over the past 13 years. If mainstream firms shut out diverse fund managers or won’t let them port their investment track records to new firms, we have to ask how women and people of color are supposed to obtain track records in the first place.
If diverse fund managers manage to pass the track record requirement, next up is the “worked together before” criteria. But here again, if 99 percent of women and people of color can’t get into mainstream firms, how can they build a record of working together?
Then there is the “invested together” requirement. To have invested together, fund managers must have personal wealth and aggregated capital, independent from third parties. Most diverse managers, especially those who are underrepresented, do not have the personal or the friends-and-family funds to invest without outside pooled capital.
Finally, unsupported beliefs about the relationship between risk and fund size also lead foundations to exclude diverse fund managers by setting large, minimum-target fund size requirements, often over $100 million. Very few first-time or diverse fund managers are raising funds over $100 million. The usual $100 million to $2 billion fund size, or assets under management (AUM), requirements create a bias in favor of those who already have access to capital. Furthermore, these requirements aren’t enforced equally. We know of one case where a public university pension fund lowered its goalposts for a sub-$100 million, first-time fund led by two white men who had never worked together. In contrast, we know a woman-led fund that met the $100 million AUM mark set by an investor, only to be told that it wasn’t good enough and the bar had changed to $200 million. The goalposts move, and not in the direction of equity.
To support diverse fund managers, foundations can instead invest in funds based on domain expertise, operational experience, deep knowledge, differentiation, and other risk-mitigation strategies. They can reduce minimum fund-size thresholds and honor their stated AUM targets. They should also post their track record of investing in funds owned by women and people of color, so that fund managers can perform due diligence on them.
3. Confront Blind Spots
Despite the commonly held view that there aren’t enough fund managers who are women or people of color, the talent pipeline is not the problem. Rather, foundations—along with their advisors and consultants—keep returning either to the same, well-networked, white managers (mostly men, though in the philanthropic sector, increasingly white women) or to the same, small pool of oversubscribed funds led by the few women and people of color they know about. The stubbornly low number of funded diverse managers hasn’t changed over the last 20 years. It also shows that oversubscribing to a handful of diverse fund managers doesn’t move the needle or scale investment for diverse fund managers as a whole.
The obvious solution is for investors to expand their network. There are many investing resources and events that center women and people of color—including VC Include, Gender Smart Investing Summit, SheEO, Private Equity Women Investor Network, Latinx VC, and Black VC. Investors need to get comfortable with being uncomfortable and start showing up.
It’s also worth noting that women and people of color spend a higher proportion of their time and money on responding to due diligence requests in order to overcome the risk misconception. If foundations decide in the end not to invest in diverse fund managers, they must commit to providing an honest debrief and constructive feedback on why the investment strategy wasn’t a fit, sharing any concerns about the management team, and offering any concrete changes fund managers can make to satisfy the foundation’s requirements. As Angela Matheny, director of investment staff at Crewcial Partners, said to us, “Providing feedback has been a very intuitive strategy for building trustworthy relationships, credibility, and respect, particularly in the diverse asset manager community.”
4. Be Better than Mainstream Investors
Disproportionate foundation investment in funds led by white men replicates the dynamic at play in the broader financial industry, where women and people of color have to work harder for less access to capital. Funds owned by women and people of color combined manage just 1.3 percent of the investment industry’s assets, according to the Knight Foundation, despite performing as well as or better than non-diverse funds. That has the knock-on effect of curtailing the flow of capital to diverse businesses: Women founders overall receive less than 3 percent of venture capital, a Diana Project study found. Women of color receive even less—less, in fact, than they did 20 years ago.
Foundations won’t change the status quo by trickling philanthropic money to efforts that support diversity, but they can change it by investing at scale in diverse fund managers. This is where “trickle-down economics” actually works: Fairview Capital found that diverse managers invest in diverse founders, who hire diverse employees. For example, women or people of color held executive positions at 40 percent of one diverse fund manager’s 650-plus portfolio companies.
And as we mentioned at the beginning, to truly support women and people of color, foundations need to provide true catalytic capital. They are well-positioned to serve as institutional anchors and could change the game for rising fund managers. If the largest foundations invest billions, other investors will follow.
5. Be Willing to Fire Your Advisor
Toniic research shows that investment advisors can help—or hinder—the deployment of funds toward social or environmental impact. Incumbent foundation investment advisors often drag their heels about doing special research or hide behind the guise of fiduciary duty to maintain the status quo. This handcuffs foundation trustees who want to invest with any social or environmental mission; advisors hold a lot of power and some foundations feel beholden to them.
Often, the first barrier is a young white male analyst without the experience and understanding of diverse perspectives, or if the analyst is diverse, they don’t have decision-making power.
Reputation management is another problem. While advisors are supposed to serve the foundation’s goals, fears about an investment not working out as expected drives them to convince leadership that considering anything other than traditional risk and return measures goes against fiduciary duty. “There is one risk never mentioned by due diligence teams: reputational risk,” said Rachel J. Robasciotti, founder and CEO of Adasina Social Capital. “This is the most difficult barrier to break through.”
Foundations that want to make progress must be prepared to fire resistant advisors. If boards vote with their feet, advisors will pay attention. Foundations should instead find an advisor or consultant who is committed to diversity and add a racial equity mandate for anyone they work with.
Foundations can and should be leaders on investing in diversity. Deploying all of their assets as a tool to dismantle structural barriers and promote greater equity would be powerful and catalytic. As simple as they may seem, these five recommendations can drive radical and transformative change—today. The data, research, and resources are out there. No more excuses.