Black venture capital and growth investors have a much harder time getting funding than white investors, because—despite efforts to bring more racial diversity to financial services—private equity’s gatekeepers remain mostly white, according to new research.
Very few of the private equity funds that fund young businesses are owned by Black or Hispanic founders and partners, traditionally the most likely source of capital for minority business ventures, says Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School.
“When you look at net worth and compare minorities to majority populations, particularly historically disadvantaged minorities, there's also income gaps, but the wealth gap is just really huge.”
What’s more, minority-owned private equity funds face a significantly higher bar for success than white-owned funds, says Lerner, in a working paper coauthored with Johan Cassel, an assistant professor at Vanderbilt University, and Emmanuel Yimfor, an assistant professor at the University of Michigan.
Their study revealed a number of stumbling blocks for minority-owned private equity funds, defined as having more than half Black or Hispanic founders or senior partners. Significantly, they are more likely to be penalized than white-owned funds when they underperform, and they are less likely to reach fundraising goals.
The opaque, risky nature of private equity—whose American roots go back to the Gilded Age—has made it a draw primarily for institutions and the ultra-affluent. However, the fortunes of startups and struggling mature firms can depend on private funds, making the study’s results particularly influential to wealth distribution in the United States.
“There is a huge wealth gap in the United States,” says Lerner. “When you look at net worth and compare minorities to majority populations, particularly historically disadvantaged minorities, there's also income gaps, but the wealth gap is just really huge. And how is it that people create wealth? Certainly, financial services. That's been one of the important ways that they do it.”
The color of money is mostly white
The total share of assets managed by minority-owned firms in 2021 was 1.4 percent, according to Lerner, while minorities that year made up over 40 percent of the population.
Lerner and colleagues built a database of 168 minority-owned private equity groups by combining information from data analytic firms like Burgiss and PitchBook with SEC filings and research from public sources like LinkedIn, news articles, commercial datasets, and private communications.
The researchers noted that minority-owned funds, just like non-minority owned funds, are more likely to finance people like themselves. In fact, owners who are minorities themselves were three-to-four times more likely to fund minority entrepreneurs than were funds run by white managers. But because minority-owned funds make up such a tiny percentage of private equity funds, the result is that relatively few minority businesses get funded.
Black and Hispanic-owned funds raised only 2.4 percent of total private capital in the study sample, according to the researchers, and minorities found it much more difficult to enter the market by raising their first fund. The mean non-minority fund raised almost 50 percent of its goal, while the mean minority fund raised only about 25 percent.
Follow-on funding
One of the most surprising findings, say the researchers, was that Black- and Hispanic-owned funds are held to a higher standard of performance than white-owned funds when they attempt to raise follow-on capital, the additional funding businesses often seek at a later stage. This sensitivity to fundraising performance, the researchers found, was almost three times higher for minority-owned groups.
“When you actually look at the deals that the minority groups exit, they do just as well as the majority groups.”
When a Black- or Hispanic-owned fund performs above average, it is able to raise funds at the same rate as white firms. But if its performance is poor, it is punished more harshly.
Lerner and colleagues examined many possible explanations for this discrepancy, including whether minority groups overvalue the businesses they fund and the possibility that investors fear that minority funds won’t be able to add staff during a growth spurt. But, says Lerner, they found no data to back up such theories.
“When you actually look at the deals that the minority groups exit, they do just as well as the majority groups,” says Lerner. “And if anything, they seem to be more conservative in valuing things.”
Additionally, the minority groups were able to scale up staffing when necessary and were not doing smaller investments than the white-owned funds.
When race is in the news, minority-owned funds do better
The researchers conclude that the difficulties faced by investment groups owned by people of color are consistent with the presence of discrimination.
They make that case by looking at two factors. First, when race is in the news, such as after George Floyd’s 2020 murder, minority-owned funds gain visibility. To test this theory, the researchers looked at periods after high-profile police killings to monitor the performance of minority-owned funds.
“Indeed, you do see this temporary blip where groups get more funds,” says Lerner. The likelihood of a minority-owned group raising a fund is 60 percent higher in these periods of high racial awareness.
They also looked at public pension fund data in states where a minority chief investment officer was hired. The likelihood that a minority fund gets an investment from a local pension with a minority CIO was 20 percent compared to 4 percent from a pension with a non-minority CIO.
“Again, you see this quite sharp uptick in terms of the willingness to fund diversely-owned groups during that period after the CIO comes in,” Lerner explains.
Policy prescriptions for the future
Knowing that at least part of the reason minority-owned funds face higher bars to success is because of discrimination, Lerner says that “easy solutions are few and far between.”
Even so, he believes a publicly available resource listing minority-owned funds would be a simple way to give motivated investors an opportunity to find these companies more easily.
In addition, says Lerner, there should be an effort to compile the experiences of asset-owners (such as endowments and pensions) to capture best practices. Those might include lessons on how these capital sources have diversified their investment staff and how they have proactively sought out minority funds to invest in.
“Those are two ideas that aren't hugely expensive, which don't require all sorts of fancy legislation, but that could potentially make a big difference,” says Lerner.
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Feedback or ideas to share? Email the Working Knowledge team at hbswk@hbs.edu.
Image: iStockphoto/cagkansayin