At a congressional hearing on diverse asset managers before the Committee on Financial Services in June 2019, Rep. Maxine Waters drew a line in the sand. She noted that in the past, when diversity efforts in financial services failed to gain traction, "we let it go," but she insisted that in the future, "It won't be that way anymore." She was speaking of the need to not merely discuss investing in diverse managers, but to begin taking concrete actions that will see asset owners and institutional investors actually deploy capital.
Fast forward one year and attention in Washington has since turned to other pressing matters — from the upcoming election to, more recently, the response to the COVID-19 pandemic and ongoing social unrest.
The attention deficit seems to underscore that while awareness can certainly help, progress will ultimately be found through a market that doesn't just recognize the challenges confronting diverse managers, but takes the necessary steps to eliminate the barriers. The data suggest investors will be rewarded for doing so, in the form of alpha and fund manager outperformance. The question facing the industry, however, is whether the market will revert to old habits and old standbys against a suddenly uncertain backdrop in which asset owners now have to contend with volatility that upsets target allocations, creates possible liquidity issues (particularly among endowments), and imposes significant due diligence challenges in a shelter-in-place world.
Emerging managers are generally defined as asset management firms with majority employee ownership and less than $2 billion of assets under management. There are often other guardrails, such as caps stipulating that assets can't have exceeded $5 billion or that the firm hasn't been in business for longer than 10 years. Within private equity, fund managers can be considered "emerging" if they're raising either their first, second or third funds. And sometimes acknowledged synonymously with emerging managers are MWDBE (minority-, women- and disabled-owned business enterprises) firms, which are generally not beholden to limits on AUM size or tenure in business.
While awareness about the need for diversity has become more pronounced recently, notable obstacles still stand in the way. Consider, for instance, just the nomenclature. This was a point that Congresswoman Joyce Beatty brought up during the question-and-answer segment of the June 2019 Congressional hearings, noting that "emerging manager" was once "characterized as a term for women- and minority-owned firms" before expanding to cover newer firms with shorter track records and relatively smaller AUM bases. Ariel Investments Chairman and CEO John Rogers noted that one of the unintended consequences is that "well-meaning, progressive decision-makers think they have hired minority firms when, in reality, they haven't." He estimated that 80% of emerging managers now share the same demographic composite as most other majority-owned firms.
But other obstacles are more systemic in nature. The challenges of women, minority and disabled business owners to break into entrenched networks, for instance, can be self-perpetuating if diverse candidates aren't advancing into decision-making roles or are regularly hitting a glass ceiling.
Not to be overlooked, the manager selection process, even if strategies are in place to consider emerging managers, increasingly tilts the odds toward incumbent players with economies of scale. This tendency could become even more pronounced during a recession, when asset owners skew toward re-ups and "brand-name" fund managers, in whom all the other major investors have invested, and move away from engaging in maverick risk.
The implicit or unconscious biases that influence investment decisions also present roadblocks that can be harder to discern. One study out of Lulea University of Technology, for instance, documented the radical differences in how venture capitalists spoke about male and female entrepreneurs. The authors observed that "men were praised for being viewed as aggressive or arrogant, while women's experience and excitement were tempered by discussions of their emotional shortcomings." Not surprisingly, women were also denied funding at a far greater frequency than their male counterparts and when they did receive commitments, they only received a quarter of the amount applied for. The men in the study, on average, received over half of their desired funding.
One of the biggest challenges that remains is the unwarranted stigma that accompanies emerging manager mandates, in which institutional investors falsely believe their decisions to hire diverse-owned managers comes with associated opportunity costs. In many ways, this is the same misconception that tends to follow ESG-oriented firms that focus on environmental risks. In both cases, empirical evidence has disproven these claims and actually favors the opposite. That is, civic-minded investors typically benefit by allocating to ESG portfolios and that highly qualified emerging- and diverse-owned asset managers are oftentimes outperforming both their peers and majority-owned counterparts, citing characteristics such as diversity of thought as a key contributor to their success.
This is not to say the industry isn't trying to promote diversity. Emerging- and diverse-manager programs have become quite commonplace among public pension plans, creating a dedicated pool of capital for new fund managers and MWDBE-designated firms. Fellowship programs, such as the Robert Toigo Foundation, and networking groups, like the Ellevate Network, have also provided a path into financial services and a support system necessary for success. Moreover, the growth of ESG investing has begun to mainstream an appreciation for the positive impact of diversity on financial returns. Yet, despite these efforts, diverse-owned firms represent barely a percentage point of the total AUM across all asset classes at 1.3%.
If the conventional wisdom 10 years ago implied that MWDBE commitments required a compromise, the data, today, proves otherwise. Broadly, across most asset categories, research conclusively shows that returns in general are statistically indistinguishable between diverse-owned and non-diverse-owned firms, according to Bella Research Group and Harvard Business School. And when looking at specific asset categories, diversity often translates into outperformance. The National Association of Investment Companies, for instance, found that an index of diverse private equity funds outperformed the Cambridge U.S. Private Equity index 62% of the time on both an internal rate of return and a multiple of invested capital basis.
Of course, this begs the question of why minority-, women- and disabled-owned managers have been unable to gain a larger share of the AUM pie. As a consultant, Meketa regularly hosts emerging manager investor days to provide a venue for diverse and emerging managers to outline their strategies and initiate relationships with prospective investors. These events build on a dedicated effort to identify and evaluate diverse and emerging managers in every asset class, while supporting organizations such as the Toigo Foundation, the Association of Asian American Investment Managers and Women Investment Professionals, among others, to support the industry's broader diversity and inclusion efforts.
The lack of asset growth can seem discouraging, but signs of progress are becoming evident. For instance, there has been a gradual shift in the strategies of MWDBE firms from more commoditized strategies (such as large-cap public equities or high-quality bonds) to more specialized skill sets in the alternative asset classes.
This is becoming evident at Meketa's twice-annual emerging manager days, as the proportion of private equity, venture capital and hedge fund managers has grown considerably over time. This shift is critical if MWDBE funds are to grow their proportion of the fee schedule, which is an equally if not more important metric than pure AUM growth. This is particularly the case as fee-sensitive investors increasingly gravitate to passive strategies for more commoditized beta exposures. Fees, in effect, have become a proxy that can measure the value of managers and their ability to add alpha to the more comprehensive investment strategies of asset owners.
While institutional investors will certainly be distracted by the current environment, this is not the time to put diversity on the back burner. In fact, many of the best-performing fund managers have taken root during similar dislocations. Robert Smith, for instance, launched Vista Equity Partners amid the dot-com crash in 2000, while Kirsten Green launched Forerunner Ventures in the immediate aftermath of the global financial crisis. It may require moxie, but dislocations such as what the market is experiencing amid the coronavirus pandemic can represent an ideal entry point for emerging manager commitments. And it's as good a time as any to turn talk into action.
C. LaRoy Brantley, principal (investment consulting), Boston; Judy Chambers, managing principal (private markets), New York; and Alexandra Wallace Stone, principal (investment consulting), Boston, each serve as co-chairs of the emerging and diverse manager committee at Meketa Investment Group Inc., while Brandon Colon, managing principal (investment consulting, marketable alternatives, and public markets), Boston, serves as co-director of the firm's public markets manager research. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.