More institutional investors have been paying attention to the social aspect of environmental, social, and governance (ESG) investing this past year than they historically have, especially when it comes to pushing for greater diversity, equity, and inclusion (DE&I).
But those calls come with their own set of challenges that investors are working to address, particularly at private equity (PE) firms, which are under less scrutiny and are less transparent than public companies.
Last year, women made up one-fifth of senior leadership in private equity firms, compared with 30% in public companies, according to consulting firm McKinsey and Company. When it comes to racial diversity, just 1% to 2% of private equity firms were made up of Black managers, trailing behind the ethnic and racial composition of the larger US population.
“Many PE firms have made great strides in the past year on diversity, equity, and inclusion, and I think as an industry there’s still more that can be done,” said Alexandra Nee, partner at McKinsey’s Private Equity & Principal Investors Practice. She leads the consulting firm’s diversity and inclusion work for investor clients and is one of the co-authors of the report.
Challenges around diversity disclosures make measuring progress difficult. While increasing diversity at private equity firms and their portfolio companies has been linked to improving returns, experts are still working to nail down standard definitions for diversity.
“At what level of granularity is it helpful to know the detailed racial and ethnic diversity breakdown within a team, particularly across multiple geographies? And at what point are you starting to carve those slices so thin that you don’t really have meaningful insight?” said Jennifer Choi, managing director at the Institutional Limited Partners Association (ILPA). She’s leading the diversity, equity and inclusion initiative at the trade group.
Standards for diversity can change based on region. While racial and ethnic identity might be the most material factors in the US, elsewhere abroad, religious minority groups could be more significant.
Access to disclosures is another challenge: Restrictions on what employers can disclose about their employees vary between the US and other countries. For example, Europe typically has more robust restrictions to protect the privacy of its citizens. The size of firms also matters: In the US, many portfolio companies are not large enough to be required to fill out self-identification forms for the US Equal Employment Opportunity Commission (EEOC).
There is also a thorny set of ethical considerations. Requiring employees to self-identify can help firms document progress toward greater diversity, but it can also endanger workers. Trustees or employees who are LGBTQ+, for example, should not be required to disclose information they have yet to share with their family or loved ones.
Seeking answers to the legal, ethical, and political considerations is still in its early days, experts say, but it will be helpful as more investors work diversity into their workplace and investment. According to an NEPC survey, 70% of endowments and foundations are prioritizing the diversity gap this year.
Other notable allocators have been helping firms move in that direction. Earlier this year, Raytheon Technologies’ Robin Diamonte said her investment team will start a diverse manager program to pressure firms to form inclusive teams. Yale’s David Swensen similarly wrote to the endowment’s managers saying the same last year.
Here are some best practices McKinsey’s consultants recommend for private equity firms to increase the number of underrepresented groups:
- Public Commitments: Investors can start communicating their commitment to DE&I to the public and to stakeholders, such as by hiring internal committees or chief diversity officers. They can also make their policies accessible and viewable on their websites.
- Conduct Evaluations of Targets: Private equity firms can incorporate diversity assessments into their due diligence of their firms, while also eventually integrating it into their 100-day value creation plan.
- Company Performance: Leadership can evaluate the performance of their firms on diversity and inclusion, and even link compensation to improvement of certain metrics.