Sponsors and dealmakers can satisfy investor demand for greater diversity and leverage opportunities for fund innovation.

Diversity has become a key focus for every industry in recent years, and private equity, like many other parts of the financial sector, still has significant progress to make in terms of diversity and inclusion. Private equity lags behind others in the financial services industry across a range of diversity metrics — according to a report published by EY in December 2021, just 10% of private equity roles are held by women.

Amid a drive to boost diversity across the industry, PE funds are becoming more diversity focused in Europe, as investors and regulators demand change and sponsors seek a competitive advantage through diversity strategies.

LP focus

LPs are placing greater emphasis on diversity at GP manager and portfolio company level, and are asking for more information on diversity, equity, and inclusion (DEI) metrics. According to Private Equity International’s LP Perspectives 2022 survey, one in five LPs refused to invest in a PE firm due to the lack of diversity at GP level.

As PE firms strive to make progress, diversity-focused funds are now coming to market with specific mandates to select investments based on diversity criteria. Diversity criteria may be considered at both GP and portfolio level, for example, by setting minimum requirements for diversity of key people or carry recipients, or diversity of “C-Suite Executives” in portfolio companies.

Regulatory focus

EU regulation is placing greater emphasis on DEI, demonstrating growing appetite for change. For example, the EU’s Sustainable Finance Disclosure Regulation (SFDR) regime (which depending on structure, GPs are likely to be subject to, if based in Europe or marketing into Europe) requires consideration of metrics on board gender diversity and unadjusted gender pay gap in certain circumstances, including where investments are intended to meet the definition of “sustainable investments” under SFDR.

UK regulators are also ramping up their focus on DEI. Last year, the Financial Conduct Authority, the Prudential Regulation Authority, and the Bank of England published a joint discussion paper on improving diversity and inclusion in the financial sector, addressed to all UK-regulated firms. The regulators highlighted that research shows evidence of correlations between diversity and inclusion and positive outcomes in risk management, good conduct, healthy working cultures, and innovation, with these outcomes directly contributing to the stability, fairness, and effectiveness of firms in the financial sector. The UK regulators therefore have a strong interest in developing policy initiatives to help facilitate a more diverse and inclusive industry.

Portfolio focus

These positive outcomes are not limited to regulatory matters. For sponsors, a greater emphasis on DEI could reap financial performance benefits. A 2020 McKinsey report found that companies with greater gender and ethnic diversity are more likely to financially outperform their peers, as they benefit from a broader range of views.

As PE firms reflect on these changes, we believe there is an opportunity for sponsors to enhance diversity and meet the growing demand from investors for further action. Beyond diversity-focused PE funds, there is also scope for dealmakers to innovate, for example by tying management incentives to achieving diversity targets, thereby leveraging deal architecture seen elsewhere. In our view, GPs that position diversity at the forefront of their strategies will be well placed to adapt in the years ahead.

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