Diverse private equity firms (referred to here as diversity, equity and inclusion [DEI] firms)¹ are an expanding and critical component of both the emerging manager and broader private equity (PE) industry. Yet these firms are underserved. That is, funds raised by DEI firms do not fully reflect the strengths these firms can potentially bring to private equity investing, including:

• Comparable performance to non-diverse PE firms
• Ability to provide access to niche strategies, a more diverse group of entrepreneurs and differentiated deal flow
• Specialized skills needed to drive value creation and returns for the small-cap to mid-cap companies that DEI firms often invest in.

DEI firms have increased in number and assets under management (AUM) over the last several years due in part to a greater awareness of DEI concerns among investors of all types and within society at large. Embracing DEI is also an important component of the “social” criteria measured and scored in environmental, social and governance (ESG) ratings. Yet, DEI firms continue to face two fundamental challenges: fundraising and growing their small institutional investor base.

Simply put, the potential of DEI firms has not yet been fully recognized—pointing to an untapped opportunity for private equity investors.

A meaningful investment with a DEI private equity firm can help establish a long-term mutually beneficial partnership. For the DEI firm, that can mean increasing visibility, fundraising prospects and deal flow. For the investor, it may provide preferred access to future fund investments, secondaries and typically no-fee co-investment opportunities. There is, of course, as in all private markets, divergence in manager performance, but investing in top-quartile DEI private equity firms may be one way for investors to meet both their return and social objectives.

Tapping an overlooked market

In the past, a paucity of data made it difficult to evaluate the relative performance of diverse vs. non-diverse private equity firms. But that is changing. Two recently updated reports add further confirmation to previous findings that the performance of diverse private equity firms is comparable to that of their non-diverse counterparts:

• The Knight Foundation’s 2021 report finds no statistically significant difference in performance between U.S. private equity funds that are minority- or women-owned and those that are non-diverse-owned, based on robust regression analysis used to isolate the impact of diversity on performance.²
• A 2021 performance study by the National Association of Investment Companies (NAIC) finds NAIC PE Index firms have outperformed their Burgiss median benchmark over long periods of time (Exhibit 1), while 40% of those firms have demonstrated top quartile performance.³

NAIC PE Index firms have outperformed their Burgiss median benchmark* over long periods

Exhibit 1: PERFORMANCE FOR THE NAIC PE INDEX VS. BENCHMARKS*

Source: NAIC, Examining the Returns: 2021-The financial returns of diverse private equity firms, November, 2021; data as of September 2020. *Results are based on a sample of NAIC private equity member firms. Burgiss benchmarks shown are custom benchmarks, constructed to align by attribute (e.g., vintage year, strategy and geography) with the NAIC sample for comparison purposes. See the NAIC November 2021 report for details.

Despite at least comparable performance relative to non-diverse firms, diverse private equity firms remain underserved; minority- and women-owned firms represent 5.1% and 7.2%, respectively, of private equity industry firms but manage a smaller share, roughly, 4.5% and 1.6% respectively, of the industry’s $5 trillion in U.S.-based AUM.⁴ That said, the number of representative firms and amount of capital raised continue to grow, providing opportunity to narrow the fundraising gap. Consider:

• The number of diverse private equity firms among the NAIC’s membership has more than doubled to approximately 81 firms in the last four years.⁵
• Women- and minority-owned firms’ private equity AUM is still only a fraction of industry AUM (Exhibit 2). However the AUM growth rates (23.2% for women-owned and 27.4% for minority-owned firms) exceeded the 18.3% rate for non-diverse firms over the 10-year period ending in 2020.⁶

On an AUM basis, women- and minority-owned private equity firms still have low industry penetration, but their AUM growth rates have out-paced that of non-diverse firms

Exhibit 2: Non-diverse, women-owned and minority-owned U.S.-based private equity AUM (in billions)*

Source: Knight Foundation; data as of September 2021.
* Women-owned and minority-owned PE firms are defined here as those with over 50% ownership by women and minorities, respectively. The definition of “minority” includes racial/ethnic minorities (i.e., Hispanic, Black and Asian), but does not include other underrepresented groups such as veterans or persons with disabilities. For details see Knight Foundation/Bella Private Markets, “A study of ownership diversity and performance in the asset management industry—2021.”

Gaining an edge in niche strategies and differentiated deal flow

One of the key strengths that DEI firms bring to the table is their insight into the small-cap to mid-cap market segment that large private equity institutions may overlook. DEI firms leverage their personal networks and build relationships with these prospective sellers that may better position them to win competitive deals. Examples of DEI firms and opportunities include:

• A minority-owned healthcare services firm/emerging manager that specializes in the niche segment of supply chain services: The firm’s two most recent funds and co-investments in companies offering innovative supply chain solutions have been strong performers.
• A minority-owned firm/emerging manager that leverages a deep operational approach to natural health and wellness investments: All six deals completed during the firm’s fundraise were sourced on either a proprietary or limited auction basis.
• An established, women-owned, consumer oriented, small firm focused on the active and sustainable living sector: The partners have extensive investment experience in their niche strategy and a well-known brand, which gives them a competitive advantage in sourcing, especially with entrepreneurial sellers.

Naturally, investments with DEI firms should be put through the same in-depth diligence and investment approval process as investments with any other firm. But, as investors, we have found that identifying top DEI firms often requires a different and more resource-intensive approach to sourcing. Many DEI firms may not use traditional placement agents or intermediaries for fundraising. As a result, to discover promising DEI opportunities, investors must engage with industry trade groups and alumni organizations to meet people and establish networks. In addition, developing a robust pipeline of leads requires strong data collection capabilities and systematic tracking of all investment opportunities to highlight those generated by DEI firms.

Securing preferred allocations

By committing a significant amount of assets and becoming a trusted partner with DEI firms, investors may obtain preferred access and allocations to future investment opportunities including funds, secondaries, and typically no-fee co-investments. Establishing a closer relationship with the general partners (GPs) provides the investor with additional dialogue opportunities outside of formal fundraising or periodic investor meetings–essentially allowing early diligence on the GPs’ next fund or co-investment. Preferred allocations are typically offered by GPs to their most trusted and reliable partners first, providing them with potential opportunities to enhance returns over time.

Conclusion

There is ample evidence demonstrating that the DEI segment is a dynamic and rapidly growing market worthy of greater investor attention. Connecting with DEI firms presents opportunities to not only fulfill ESG and diversity goals but also to potentially earn robust returns. By forming relationships with DEI firms, investors can garner access to the differentiated deal flow and specialized value creation skills that give these firms the potential to outperform their peers over the long term.

¹ While there is no industry standard definition, our Private Equity Group (PEG) categorizes a firm or co-investment opportunity as diverse (DEI) if individuals who are women, Black, Hispanic, Latino, Native American, Asian & Pacific Islanders, LGBT+, military veterans and people with disabilities comprise at least 30% of its key persons–or if 30% or more of its economics (carried interest) is held by members of these groups.

² Josh Lerner, Rahat Dewan, Jake Ledbetter, Alex Billias, Knight Diversity of Asset Managers Research Series (Industry): “A study of ownership diversity and performance in the asset management industry—2021,” Knight Foundation/Bella Private Markets, December 2021. In this study, “women-owned” and “minority-owned” firms are defined as those with over 50% ownership by women and minorities, respectively. The definition of “minority” includes racial/ethnic minorities (i.e., Hispanic, Black and Asian), but does not include other underrepresented groups such as veterans or persons with disabilities.

³ Examining the Returns: 2021—The financial returns of diverse private equity firms, NAIC, November 2021.

⁴ Knight Foundation/Bella Private Markets, "A study of ownership diversity and performance in the asset management industry—2021.”

⁵ NAIC, Examining the Returns, 2021 and 2017 studies, November 2021, April 2017.

⁶ Knight Foundation/Bella Private Markets, 2021.