Context Matters
Decision-making across identities relative to venture investment and fund performance
Thank you Monica Roman and Robert Gottlieb for the brilliant feedback on this piece.
Gradually over time, both men and women have challenged the traditional understanding of “rationality,” arguing that rational thinking should not be defined by sex or gender identity. In investing, schools of thought such as behavioral finance suggest that investors act more or less “irrationally” due to a series of cognitive, emotional, and social influences, leading to suboptimal decisions and market underperformance. As diversity in the finance workforce nears parity, new data continues to uphold investors from all walks of life and their capabilities to draw justifiable, data-driven conclusions and use defined rules and logic to make rational decisions.
On the private equity front, a number of studies, reports, and articles have been published describing quantitative differences between men and women investors and their investment performance. While datasets and investment performance vary across evaluations, this recurring research generally points to a consistent reflection — when in a check-writing position, men and women may think differently about the same potential investment, but collaboration between individuals from different backgrounds and across identities can result in superior investment performance.
In exploring how and why this is the case, as well as the significant differences in thought that exist across the identity spectrum that could affect investment performance, we can further demonstrate why we must advocate for new normative investment standards in today’s capital markets that are grounded in inclusive principles.
Under frameworks and experimental literature such as Bordalo et al. (2016), stereotypes in small organizations could persist if they contain an overweight number of representative members of a group and make infrequent hiring decisions. The institutional investment setting, particularly from the private equity and venture capital lens, has a number of important attributes that make it an ideal setting to explore the performance implications of diversity — one of which is firm size (and how it changes over time). Firms tend to be small with typically less than a dozen investment professionals and do not hire often, if at all, outside of the core investment team. From a survey of 13k+ venture capital professionals, Gompers et al. (2016) found the average firm employs 14 people, only five of whom were senior partners in decision-making positions. In addition from social psychology, Klocke (2007) shows small groups are more likely to be homophilous i.e. tend to associate with similar identities, and to have biases aggregated into expressed decision-making. These findings together may lead us to believe that a slight preference over certain demographic characteristics, like sex or gender, could aggregate into a sustained overall lack of diversity at the sector level.
We have seen that men continue to hold a vast majority of the finance sector’s decision-making roles, with private equity and venture capital being notable examples. Today, women make up just 15 percent of general partners at venture capital firms, up about 3.5 percentage points from data collected in 2019, according to Pitchbook. GPs (general partners) and their founding teams are not all to blame for these circumstances. From a different but relevant diversity perspective, a group of researchers from Stanford University and Illumen Capital modeled profiles of emerging fund managers raising their third venture fund, demonstrating that asset managers do not perceive white and Black fund managers the same way. When submitting fictitious profiles to asset allocators for evaluation, they altered only the race of the managing partner. Profiles of successful funds, indicated by previous fund returns, the number of exits, and partner credentials, were given lower ratings on criteria such as fund performance, investor skills, and social fit when the managing partner was Black, the researchers found. If women have experienced similar biases from LPs (limited partners) when raising funds, for example, we may further ascertain some of the systemic absence of diversity among decision makers in this space.
In terms of qualitative and quantitative investment perspectives on this topic, a study by Calder-Wang and Gompers (2021) seems to be the most holistic among research published in the last decade+. In this study, the team gathered a sample of investments (just under 11k deals) and venture fund IRRs from Preqin to the degree of 395 funds (data from 1990–2016). Because IRRs vary by investment focus and year, excess IRR was used, defined as the fund-level IRR minus the median fund return for venture capital funds raised in the same year and geographic region. Results suggested that greater gender diversity has economically and statistically significant effects on deal-level outcomes and fund-level excess returns. Success rates on individual deals improve by 4.7% with a 5% increase in gender diversity (namely, increasing the fraction of women hired from a baseline level of approximately 10% to 15%). Greater gender diversity was somewhat correlated with fund excess IRR in the analysis, but was positively, statistically significant at rates between 4.2% and 4.7%.
While data quality and relevancy is important to be aware of, the conclusions positively support the idea of a more diverse investment community and the economic productivity that is possible within it. Along with the quantitative conclusions in their study generally falling in favor of inclusivity, the qualitative conclusions were pragmatic in regards to how firm diversity (and how that occurs) may impact investment behavior.
The core of this study was to better understand how the gender of an investor’s children may affect their investment performance and decision-making, but interesting findings arose in regards to its effects on firm personnel. When existing partners have a higher number of daughters relative to the total number of children, hiring biases against women are reduced, substantially increasing the probability of hiring a female investor to the firm at a clip of 45%. Additional perspectives from the study lead to an important observation in regards to differences in investment behavior through diversity, finding that the presence of a female investor is significantly related to the fraction of female founders in a firm’s portfolio — somewhat of a trickle-down effect. While a correlation could be drawn between partner children’s gender affecting performance (and investing in more female entrepreneurs), it is only through actually hiring a female investor to the firm. Having daughters in and of itself does not increase the fraction of female entrepreneurs in the firm’s portfolio.
Additional data to correlate to alternative investment behavior across identities was revealed in a field study conducted on Q&A interactions at TechCrunch Disrupt New York City during 2010 through 2016. It was found that investors can have implicit biases towards founders, tending to ask male entrepreneurs promotion-focused questions and female entrepreneurs prevention-focused questions. This bias across different investor identities and the questions they ask founders is consistent with findings in Ewens and Towson (2020) when studying AngelList interactions. If this has steadily been the case across the private equity landscape over time, perhaps we could partially attribute this to the divergent funding outcomes for entrepreneurs and GPs seen across identities. All of these results suggest that firm and portfolio diversity must be achieved through genuine removal of a bias and/or an establishment of a renewed firm ethos to potentially lead to better economic outcomes than, say mandated diversity ratios or being a parent to a daughter.
A study was conducted at Tianjin University where it was found that men’s brains have notably more gray matter than women’s, and women’s brains have significantly more white matter than men’s. Since gray matter characterizes information processing centers and white matter facilitates the connections among those centers, researchers theorized that these differences might explain why men tend to excel in tasks that depend on pure information processing while women show relative strength in tasks that call for assimilating and integrating disparate pieces of information together.
Similarly, your background influences the way you frame problems; investment theses and judgment may differ in diverse groups to foster deeper collaboration, time spent on deals, and unique value-add post-investment. Adjacent observations by Gompers and Kovvali found that positive differences in venture investment decision quality and performance came post-investment, when the investors helped shape strategy, recruitment, and other efforts critical to a young company’s survival and growth. Thriving in a highly uncertain competitive environment requires creative thinking in those areas, and the diverse collaborators were better equipped to deliver it than less diverse counterparts. For this case, if salient diversity can generate alternative investment theses and networks, does this allow alternative perspectives to positively compound during the post-investment period?
In theory, alternative investment perspectives may be correlated with principle reasoning across identities, influencing their investment behavior and resulting in differentiated investment outcomes. If a person’s judgments tend to be governed by abstract principles, seeking specific motivation from founders and their businesses, and developing intuitive ways to help them grow over time may be somewhat misaligned and reinforce confirmation biases. On the other hand, if a person’s judgments give more weight to specific personal and business characteristics irrespective of cultural dispositions and circumstances, is there greater value in this nature as a fund manager by means of investment decisions and nurturing their active portfolio? This could potentially shed further light on pronounced investment and fund performance through expanded diversity in firm personnel. Many private equity professionals claim this business is about relationships — if a common denominator to positive economic outcomes is keen interpersonal abilities, identities who possess them may have a natural advantage in this court.
73% of women-led firms were founded in the last five years, with 67% either raising their first fund or are on Fund I. While the pipeline for women-led funds is growing, inclusion across other identities (such as race) is integral.
Kim Lew, CEO of Columbia Investment Management and former CIO of the Carnegie Foundation, has grounded her allocation philosophy in transparent, open dialogue with fund managers they invest in — constantly asking uncomfortable, potentially sensitive questions to create a culture of understanding shared values. In doing so, this sets a constructive tone that fosters communication across identities, potentially widening the scope of who can flourish as an investor. I have only spoken to a handful of fund managers and LPs thus far in my career, but I can see how this type of GP-LP relationship could generate meaningful, complementary value over the life of a fund.
The team at Sapphire Partners has posited that, too often, investing in diverse managers is discussed as something LPs “should do”, and that a homogenous lineup [of fund managers] runs the risk of potentially overlooking deals outside of one’s network, thereby capping one’s returns. Innovation happens everywhere; are LPs practicing their license to have an impact in becoming more diverse and being more intentional in their private fund evaluations/post-allocation support across identities? (with the partnership they provide, on portfolio founder composition, and believing in a manager’s shared values)
With a wealth of research to validate the greater decision-making by diverse teams, we must continue to back the untapped. Thinking ahead, I wonder how much the evolving venture tech stack will influence decision-making across identities. What new data will become available to help measure investment decisions and performance? Perhaps technology will help close the diversity gap quicker. If fund managers have the ability to be very deliberate and precise with their portfolio construction parameters, could their models help solve this dilemma or undo the progress made thus far?
For more resources regarding women and diversity in venture, check out these ideas and frameworks to continue to advance the conversation towards change:
- Nixon Gwilt Law’s 2021 List Of Venture Funds And Accelerators For Womxn
- The Untapped Potential of Women-led Funds (Women in VC)
- Diversity in VC: Learnings From an LP Audit and How we Can Make This Better Together (Sapphire Partners)
- The Story Behind Shundrawn Thomas’s Open Letter to Asset Management (II)
- How to increase diversity in asset management & Closing the gender gap in venture capital (World Economic Forum)
If you have any constructive feedback or could point me in a direction to further round these thoughts out, it would be much appreciated! Thank you.
