Private matters: the case for diversity in alternative investments
There are two types of politician. While you consider a punchline to that setup, allow me to paraphrase Max Weber on this topic. In a 1919 essay, Politik als Beruf (“Politics as a Vocation”), Weber distinguished between those who felt called to politics as a vocation and those who practised it as a profession. The former typically have a purpose, which can animate others, but conversely they may not be organised enough to harness that energy – or they may be dangerously single-minded in their pursuit of that purpose. The latter are more likely to be successful in achieving targets, but often at the cost of lacking charisma and/or being overly cynical.
As Weber puts it: “The problem is simply how can warm passion and a cool sense of proportion be forged together in one and the same soul? Politics is made with the head, not with other parts of the body or soul. And yet devotion to politics, if it is not to be frivolous intellectual play but rather genuinely human conduct, can be born and nourished from passion alone.”1
An analogous challenge is evident in investment management. The best fund managers must be visionaries, even iconoclasts, able not only to recognise opportunities and trends before anyone else but to communicate what they see compellingly too. But they must also be rigorous analysts, able to manage risk promptly.
It is vanishingly rare for one person to master both skillsets. Fortunately, the investment industry has largely moved beyond reliance on high-profile individuals, as the answer to the challenge is to blend expertise and experience through a team. We now seek to cultivate star teams, not teams of stars.
This is not a new development, but the present market environment makes it especially important to nurture such a range of aptitudes within investment teams – nowhere more so than in private assets. As true owners rather than renters of assets, investors in private markets need to see the future and make it happen. Both requirements are becoming harder. Amid rapid technological change and volatile geopolitics, investors need an acute sense of which assets are future proofed and can perform resiliently. And given tighter financing conditions and limited scope for valuation multiples to rise without an underlying justification, investors need to deliver operational improvements to generate returns. Vocational vision and professional pragmatism, sine qua non.
Diversity against adversity
It is in this context that cognitive diversity cannot just be a superficial ambition when building investment teams; it is integral. Different backgrounds yield different views, which are essential to finding the insights necessary to pick the right assets and to manage them innovatively to reach their full potential.
McKinsey’s recent report on the state of diversity in private markets2 is therefore simultaneously encouraging and disappointing. Encouraging because progress is being made, but disappointing because it still isn’t happening quickly and thoroughly enough.
On the positive side, gender parity has almost been reached at entry level, with 48% of such positions in private equity globally being held by women at the end of 2022. The consultancy extrapolates that the industry could now achieve gender parity at analyst and associate levels within 10 years.
However, the numbers are more problematic for senior roles. Only 20% of private-equity managing directors are female, while men are 2.75 times more likely than women to be promoted to principals (one rank below managing directors). McKinsey warns that at the current pace, we are more than 60 years from gender parity in private-equity investing roles at the managing-director level. There is a similar lack of racial and ethnic diversity across private equity, the research found.
Interestingly, women are more likely to join the industry in non-investment jobs, representing 59% of such entry-level recruitment compared with only 33% for entry-level investment positions. This is despite the ongoing accumulation of evidence that diversity improves investment performance. Last year, for example, the British Journal of Management published a study of 241 global private-equity buyouts for which the academic authors had full demographic information on the 547 private-equity partners who managed those deals.3
They reported that above-average sociodemographic diversity in the teams of partners (as measured by gender, age, or ethnicity) corresponded to an increase of 4.6 percentage points in the abnormal compound annual growth rate of the target’s enterprise value from entry to exit (a methodology designed to prevent leverage from skewing the results). These benefits were particularly pronounced in complex buyouts and uncertain deal environments, the researchers noted.
Similar patterns have been observed across other types of private asset. A paper released earlier this year documented, among a sample of 179 real-estate funds, a lower risk profile in those with gender-diverse leadership.4 There is more plentiful evidence that diversity enhances returns in hedge funds, including a Review of Financial Studies article last month that showed heterogeneous hedge-fund teams (by gender, race, and background) outperform homogeneous teams after adjusting for risk and fund characteristics, which the academics attribute to arbitraging more stock anomalies, avoiding behavioural biases, and minimising downside risks to generate persistent performance.5
“The strength of a political personality means, in the first place, the possession of these qualities of passion, responsibility, and proportion,” Weber wrote. We in private assets would do well to possess them too – the passion to look for transformational opportunities and breakthroughs, the responsibility to manage risks on behalf of investors, and the sense of proportion to look through short-term noise – though it’s rare for all to be found and balanced in one person. We must remain committed to building diverse teams to reflect these ideals. As private markets face a much more complex operating environment, and one cannot rely on cheap leverage nor multiple expansion, cognitive diversity is likely to separate those who thrive through operational value creation from those who may not survive.