Over the past several years, numerous studies have shown that women investors deliver superior returns across multiple asset classes – large cap equity funds, hedge funds, and private equity funds. For anyone who understands the value of diverse perspectives, this isn't surprising. What is surprising is that women-owned funds manage only a fraction of the trillion-plus dollars controlled by these asset owners. Given women managers' superior performance, this is a true misalignment of outcomes and resources.
We see the same conundrum in the venture industry, where there are also strong indications of women VCs' outperformance. For example:
- In 2018, Harvard Business School researchers concluded that in the mostly homogenous VC world, funds with diverse managers earned significantly better returns – at the individual portfolio-company level and overall.
- In a 2019 study of 180 venture funds, Greenberg Associates found that emerging managers – i.e., those that have raised no more than three funds (the category that includes most women managers) – outperformed their established counterparts.
- PitchBook data shows that 69% of venture firms that scored as a top-quartile fund between 2009 and 2018 had women in decision-making roles.
Yet, as noted in the seminal report by Women in VC, only 4.9% of U.S.-based VC partners are women and only 5.6% of U.S. venture funds are women-led. And according to PitchBook, as of August 2019, just 12% of venture firms and angel groups had women in investment decision-making roles.
Why the dollars aren't following the outcomes
As emerging managers, women VCs face formidable challenges. Most raise their funds from high-net-worth individuals and small family offices. For these investors, minimum commitments may be as low as from $100,000 to $250,000. That means hundreds of pitches and prospect meetings to raise a $20 million or $30 million fund, which can take months if not a year or more for first-time fund managers.
The key to increasing assets under management by women VCs is increasing the number of institutional limited partners (LPs) – insurance companies, pension funds, and endowments – that hold the power of the large check. This is easier said than done, however. Women VCs face numerous barriers when raising funds from institutional LPs:
- Self-imposed restrictions. Institutional investors often operate under self-imposed guidelines that limit the percentage ownership in a fund or that require a minimum investment amount. These constraints preclude these investors from investing in emerging managers whose fund size is often $20 to $30 million or less.
- Lack of track record. Some women VCs say that institutional investors frequently comment that the women-led funds don't have enough of a track record or that they would not consider investing in women VCs unless they have been partners at established name-brand VC firms, even though many have extensive corporate finance, institutional investment, or operational experience.
- Perceived trade-off of returns for diversity. In a recent survey of institutional investors, Morgan Stanley found that asset owners (pension funds, endowments, and insurance companies) perceived that incorporating diversity into their investment decisions came at the expense of returns, notwithstanding a growing body of evidence to the contrary.
- Just plain bias. And perhaps the greatest impediment is just plain bias. Research conducted by Stanford University and Illumen Capital demonstrated that institutional investors do not perceive Black and white fund managers the same way. The researchers created profiles of emerging managers raising their third venture fund where all the details about each fund's track record and qualifications were the same, except the race of the fund's managing partner. Profiles of teams with Black managing partners were given lower ratings on fund performance, investor skills, overall competence, social fit, expectations of how much the team would be able to raise, and likelihood that investors would take a meeting with the team. Although this experiment focused on race, it is not a stretch to assume that similar biases would operate against women VCs.
How to change the misalignment
Some institutional investors are making progress in allocating assets to diverse fund managers. However, there is still a long way to go before institutional asset managers pay more than lip service to diversity. Here are some things they can do:
- Recognize the fiduciary obligation. As the Illumen Capital study points out, taking diversity into account when allocating assets among managers is not only a moral obligation, it is also a fiduciary obligation – leading to fewer losses and better performance. To fulfill their fiduciary duty, Illumen notes that institutional investors must rethink their investment criteria and strategies and ensure that the decisionmakers responsible for asset allocations are knowledgeable about the success of firms led by women and people of color.
- Take a page from activist institutional investors in public equities. For years, institutional investors, through organizations like Institutional Shareholder Services (ISS), have positively influenced policies and procedures of public companies with respect to issues like climate change, executive pay, and diversity. Institutional LPs could do the same. They could self-monitor by assembling a robust database of key performance data of fund managers by gender and race and by sharing best practices for investing in those managers. They could also directly increase investment in diverse managers, through vehicles like a fund of funds or by leveraging their investment power to encourage established funds to hire more women partners.
- Revise guidelines. Whether through an industry-wide effort like ISS or individually, institutional investors could adopt new guidelines to invest in high-performing emerging VC funds that are 100% committed to gender and racial diversity. Although writing smaller checks may at first be more resource-intensive for institutional investors, doing so will help transform "emerging" managers into "established" managers.
- Adopt emerging manager programs. A number of institutional investors have established emerging manager programs with specific allocations to funds led by women and people of color. Notably, most of these programs are sponsored by public pension funds that are subject to state and local regulation and whose beneficiaries are often large populations of women and people of color. Not only do these programs provide much-needed capital to these historically underfunded emerging managers, but they will help build the database demonstrating the performance of these managers.
MassMutual has adopted one of the most innovative approaches to addressing the emerging manager funding gap. MassMutual recently used a matching strategy to catalyze a first-time fund focused on investing in underrepresented founders. With an initial investment of $5 million and a commitment of up to $5 million more to match new investments from additional LPs, MassMutual is fueling this emerging manager's fundraising efforts and increasing their ability to make impactful investments in underrepresented founders.
Why it matters
Apart from the obvious—that smart investors ought to put their money with managers who deliver superior outcomes—significantly increasing the amount of capital invested in women-led venture funds could have a potentially transformative effect on gender diversity in the startup ecosystem.
There is a clear correlation between funding of women VCs and funding of women founders. Women VC investors are twice as likely as their male counterparts to invest in companies with female founders and three times as likely to invest in companies with female CEOs. As a result, lack of funding of women VCs translates into underfunding of female founders. But on the positive side, more capital deployed by women VCs should result in more capital invested in female founders and, because female founders have been shown to outperform non-diverse founding teams, superior returns for women-led funds and their LPs.
This good news scenario will remain elusive, however, unless women VCs are able to raise larger funds more quickly. And institutional investors hold the key to making that happen. So, now is the time for those investors to dig into the data, revisit their asset allocation policies, and exercise the power of the big check. By doing so they will not only reap superior returns, but they will also unlock the way forward to a more gender-diverse ecosystem.