Diversity Boosts Profits in Venture Capital Firms

 
 
VC firms that score high in diversity among their partners also tend to be more profitable, according to Paul Gompers.
 
 
by Michael Blanding
yuri_arcurs

Recent research shows for the first time that diversity in venture capital firms not only spawns creativity and alternative viewpoints, but also improves financial performance.

Paul Gompers, Eugene Holman Professor of Business Administration at Harvard Business School, summarizes his recent research in a new article in Harvard Business Review, “The Other Diversity Dividend,” co-written with HBS research associate Silpa Kovvali.

They focused on the venture capital industry, which provided a unique laboratory for investigating financial performance. Starting six years ago, Gompers began gathering demographic information on individual VCs to better understand if their gender or race influenced a firm’s performance.

“It was a real guerilla research effort,” he says. Starting with commercial data on 14,000 VC investments in 42,000 individual startups, Gompers and his research colleagues used a program that identified gender based on names of VCs and entrepreneurs; for those the program couldn’t determine, they looked up pictures and stories.

“If I am in a firm with five white guys who all went to Harvard, it’s likely we are going to see the world in the same way and make more mistakes”

They made a similar effort to determine ethnicity, using software to assign ethnicity based on first and last name and location; for African Americans, who frequently have names similar to whites, they used a firm in India to look up pictures of individuals. Finally, they scraped information on where each person went to school from LinkedIn.

Birds of a feather invest together

The information showed that the venture capital world is incredibly homogenous, consisting mostly of white men from liberal arts colleges who majored in economics and attended business school. Harvard Business School alone accounted for some 25 percent of VCs.

What’s more, these numbers have changed little over time, with the percentage of women in venture capital staying consistent at 8 percent from 1990 to 2016, despite gains in STEM (science, technology, engineering, and mathematics) and business school degrees over the same period. Ethnic minority representation was even lower, with Hispanics and African Americans representing around 2 percent and at 1 percent respectively over the same period.

“We really saw how powerful the force of ‘birds of a feather flocking together’ was,” Gompers says. “The more similar you are to someone, the more likely you are to work with them.”

That homogeneity, however, came with a penalty: a clear lack in financial performance. Partners who came from the same school achieved an 11.5 percent lower success rate for acquisitions and IPOs; those who were ethnically homogenous saw a success rate 26 to 32 percent lower.

Despite such strong correlations, the data didn’t necessarily prove one caused the other, since there are a number of confounding factors that could skew those results. In a National Bureau of Economics working paper released last year, Gompers and research assistant Sophie Wang developed a novel way to determine exactly how much gender diversity influenced performance.

Examining reunion books from the small number of universities accounting for the bulk of venture capitalists, they determined that VC partners who had daughters were 24 percent more likely to hire women as partners for VC funds—the equivalent of a random distribution of gender diversity.

“We could then identify the component of gender diversity caused exclusively by having a daughter uncorrelated to anything else,” Gompers says. “It’s just like if you did a controlled experiment.”

Looking at the financial performance of those firms, they determined that having at least one woman in a VC fund improved performance by approximately 10 percent. That is, while the median venture capital fund return is around 14 to 15 percent, funds with a female partner returned 16 to 17 percent. Moreover, having women as partners increased the percentage of successful startups supported by those firms—that either went public or sold for more than their total capital investment—from about 28 percent to about 31 percent.

“In terms of magnitude, these things are quite big in economic terms,” Gompers says.

The higher returns could be due to one of several explanations, he says. For starters, since women face such a disadvantage in being hired in the first place, it is possible that those who do are exceptionally well qualified. “You are fishing from a richer pond,” Gompers says. A second possibility is that women might be more willing to invest in companies headed by women, seeing opportunities other funds might miss.

A third explanation is that gender diversity generates alternative perspectives that might discover new opportunities for investment. “There is a lot of psychological research showing that your background influences the way you frame problems,” Gompers says. “If I am in a firm with five white guys who all went to Harvard, it’s likely we are going to see the world in the same way and make more mistakes,” he says. “[Diversity] can help you avoid blind spots.”

More than likely, says Gompers, the increased performance is due to a combination of all three factors.

He is currently working on a way to determine whether ethnic diversity causes the same spike in financial results. Gompers is exploring possible correlations between what sport a VC partner played in college such as tennis and squash, which are played by predominantly white athletes, compared to basketball or football, to see if exposure to diverse teammates leads VCs to hire more underrepresented minorities.

Cleaning up the frat boy culture

For firms looking to add diversity, Gompers recommends first and foremost being aware of one’s own biases that can influence them to hire homogenously. “Most people aren’t bad people, but we have these internal biases to think that people who look like us are smart and capable.”

Creating a diverse company has to start from day one, he says. “Some firms say, I’m worried about survival, I’ll worry about diversity later. But it’s really hard to start from a frat boy startup culture and move to one that is open and inclusive.”

Gompers’ research shows that, while financial returns stemming from diversity may not be immediately apparent, they tend to emerge over time as the wisdom of better decision-making bears fruit.

“In the early stages, it’s hard to see that you are gaining all of those benefits,” Gompers says. “It’s really important to have a conviction that you are going to see them over time.”

Related Reading:

Op-Ed: Google Engineer Deserved to be Fired by the CEO
What Does 'Diversity' Really Mean?
How Should Managers Deal with the Challenges of Building an Inclusive Workplace?

What do you think of this research?

Share your insights below.

About the Author

Michael Blanding is a writer based in Brookline, Massachusetts

Post A Comment

In order to be published, comments must be on-topic and civil in tone, with no name calling or personal attacks. Your comment may be edited for clarity and length.