Racial Diversity and Private Capital

By Josh Lerner

Posted on March 23, 2022


What explains the lack of racial diversity in the asset management industry? In a new working paper with Johan Cassel and Emmanuel Yimfor, we examine the underlying causes of the industry’s low levels of minority ownership in the United States, focusing on venture capital, buyout, and growth investment groups.


The predominance of white owners in the asset management industry likely exacerbates America’s well-documented disparities of wealth by race. According to the Knight Foundation, groups owned by minorities managed less than 1.6% of assets in 2018, even though minorities represent 40% of the US population. This imbalance is troubling given that the ownership of private capital groups and other financial institutions has been an important driver of wealth creation.


The problem is compounded by the tendency for private investors, particularly venture capitalists, to fund people who share their own characteristics. Racial disparities in the ownership of venture capital groups may thus have substantial effects on what types of entrepreneurs get funded, raising barriers to other critical avenues of wealth and job creation.


Demand for Minority-Owned Funds


Despite differing in their coverage and performance measures, our Burgiss and PitchBook databases paint a consistent picture of racial disparity. Black- and Hispanic-owned funds represent a very modest share of the capital raised by private capital funds, relative to plausible benchmarks. In keeping with this observation, we show that it is more difficult for minorities to enter the market. Using Form D filings, which provide a broad depiction of attempted US private equity and VC fundraising, we show that Black and Hispanic-owned groups (a) are less likely to meet their fundraising goals, (b) raise smaller funds, and (c) have fewer investors participating in their funds. We also show that minority- and majority-owned funds are indistinguishable in terms of their ultimate performance, using various measures constructed with Burgiss and PitchBook data.


“Black and Hispanic-owned groups are less likely to meet fundraising goals, raise smaller funds, and have fewer investors. We also show that minority- and majority-owned funds are indistinguishable in terms of ultimate performance.”


Do minority-owned funds suffer from lower demand? To limit the impact of unobserved heterogeneity in manager quality, we focus only on the ability of established groups to raise follow-on funds. In a world of persistent performance, as has characterized private capital historically, past performance should proxy for expected returns. The inflow-performance relationship has been extensively scrutinized in a variety of asset classes, from mutual funds to private equity.


In our analyses, we find a striking result. The ability of Black- and Hispanic-owned funds to raise follow-on funds is far less sensitive to past performance than those of other funds. This is true whether performance is measured using cash flow data (to compute the public market equivalent, or PME, and other measures) or the success of relatively recent deals (those going public or being acquired). For instance, using Burgiss data, an increase in PME of one standard deviation point is associated with a 24.1% larger follow-on fund for non-minority owned groups, but an insignificant change close to zero for minority-owned groups (-5.5%).


What Happens When Racial Attitudes Change?


Do changes in racial awareness affect the sensitivity of inflows to performance? We seek to identify an exogenous shift: an event that may change the attitude of limited partners to diversely owned funds, while not affecting the prospects of the funds in the long term. It might be thought that the best approach is to use events that heightened racial awareness at the national level, such as the riots in 1992 that followed the beating of Rodney King or the presidential election of 2008. Casual observation suggests that in the aftermath of the George Floyd killing, many investors increased their commitments to minority-owned funds. But it is difficult to disentangle such shifts from the national nature of the discussions, as well as the influence of confounding events. For example, the election of Barack Obama coincided with the Global Financial Crisis, while the death of George Floyd occurred during the Covid-19 crisis.


Instead, we follow the recent sociology literature and use data on fatal encounters between unarmed citizens and the police as an exogenous variable. As a measure of racial sensitivity, we calculate the news-weighted ratio of fatal encounters between minorities and police in each state and year. During periods of high racial awareness, we find that the sensitivity of fundraising to performance is substantially greater for diversely owned funds.


Why Do Minorities Struggle to Raise Capital?


These patterns are consistent with the suggestion that the demand of asset owners differs for funds with managers of different ethnicities. Asset owners may limit the amount of capital they invest in diversely owned funds, regardless of performance, effectively eliminating the ability of many high performers to substantially increase the size of their next funds.


“The under-representation of Black and Hispanic-owned groups can at least partially be explained by demand. The lack of a strong relationship between fund inflows and performance suggests a problematic dynamic..”


We highlight how minority groups are often funded through pension funds’ emerging manager programs, in which a small amount of capital is earmarked for such groups. It may be difficult for managers to “graduate” from these programs and raise significantly more capital from the pensions. Meanwhile, in an industry with a few minority-owned funds and less fundraising success by minority-owned groups, demand for such funds may follow the traditional downward-sloping shape.


The weak relationship between fundraising and investment success for diversely owned funds may have a more benign explanation. Given that minority entrepreneurs find it more challenging to raise external debt and equity, the maturation of their firms may be slower. If such firms are more common in the portfolios of diversely owned funds, measures such as PMEs and exits may be less reliable guides to such funds’ expected future performance. For these funds, the estimates of fundraising may be biased towards zero.


But the results showing that inflow-performance sensitivity increases during periods of high racial awareness seem inconsistent with the notion that the lower sensitivity for minority funds is simply due to less informative performance numbers. If that were the case, we would anticipate that even if inflows to minority funds increase during periods of greater awareness, the sensitivity of inflows to performance would not change.


Summing Up


Together, these results support the suggestion that the under-representation of Black- and Hispanic-owned groups can at least partially be explained by demand. During “normal” times, the lack of a strong relationship between fund inflows and performance suggests a problematic dynamic. While a “set-aside” approach may assure the presence of minority managers in portfolios, it appears likely that high-performing minority groups struggle for recognition and capital. It is only during periods of sharp attention to racial issues that the dynamics appear to change. The analysis leaves many open questions for further study, including better understanding the criteria that asset owners use to select and renew managers.


Key Takeaways

Illustration: people working together at a desk
  • Despite the fact that their performance is indistinguishable from other funds, minority-owned funds control a very modest share of private capital.
  • The ability of minority-owned funds to raise follow-on funds is far less sensitive to past performance than that of other funds, increasing only during periods of high racial awareness.
  • Setting aside capital for pro-diversity programs may boost the number of minority managers, but it will remain difficult for even high-performing minority groups to access further capital.
  • The lack of racial diversity in private capital stems at least partially from the nature of investor demand, rather than the supply of available fund managers.

The preceding is republished on TAP with permission by its author, Professor Josh Lerner and by the Toulouse Network for Information Technology (TNIT). “Racial Diversity and Private Capital” was originally published in TNIT’s February 2022 newsletter.