Why Private Equity Should Really Be Paying Attention to the Board Diversity Conversation

According to research, only 10% of top-level decision-makers at venture capital firms are women.

Dustin Holloway
Nov 6, 2020 · 7 min read
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Photo by Austin Distel on Unsplash

ow diverse is your board? If you work at one of the roughly 10,400 venture-backed companies in the United States, the answer is likely “not very.” A recent study by Crunchbase and the Kellogg School for Management analyzed data on the number of women on the boards of private companies (I couldn’t find data on racial diversity on private company boards).

The study looked at 200 private companies with nearly $100 million in funding or more and found that:

  • 60% of the private companies had no women on their board
  • 7% of board seats across all 200 companies were women

For a quick comparison, as of September 2020, no S&P 500 board has 0 women, and women hold around 26% of all board seats in the S&P 500. 26% isn’t exactly gender parity, but it isn’t 7% either.

Private equity’s diversity problem

Private equity has managed to remain aloof from the board diversity conversation, for the most part. Even with the added scrutiny on board diversity in 2020, public attention and ire has been focused primarily on public companies. That makes sense. Private companies have far fewer reporting requirements than public ones, and generally prefer to keep their governance out of the public eye.

Now, there are plenty of reasons why well-funded private company boards aren’t particularly diverse — beyond the aforementioned lack of scrutiny. A significant one, though, is that private equity tends to pull from a pool that is predominantly white and male.

According to research by Axios, just under 10% of top-level decision-makers at venture capital firms are women. Meanwhile, a report by the John S. and James L. Knight foundation found that only about 3.7% of private equity firms were minority-owned.

When those firms pull from their networks, it is no surprise when the vast majority of the people they know are also white men.

Board diversity benefits

Current evidence points to a strong business case for top-team diversity, particularly at the board level. We’re not talking about a single, fringe study. Evidence for the benefits of board diversity is all over:

Higher return on equity (ROE) and earnings per share (EPS)

A study of U.S. companies on the Morgan Stanley Capital International (MSCI) World Index found that having three or more women directors was correlated with “median gains of 10% ROE and 37% earnings per share.” While many studies have documented the modest effect that a “token” diverse board member has on a board, in The Tipping Point, researchers from MSCI added language that made the concept more tangible.

The idea of a “tipping point” at 3 women, explains the notion that when a company only has one or two women on its board, they are often isolated and their perspectives rarely receive the weight that their colleagues’ do. At three women, so the thinking goes, the gravitational weight of their perspectives is high enough to merit attention in a way that it isn’t for one or two women.

Obviously, this theory demands a certain size of boards. On a four-person board, for instance, you likely do not need to reach the three-woman “tipping point” to have your voice heard.

MSCI also found “fewer instances of governance-related controversies such as cases of bribery, corruption, fraud and shareholder battles.”

Lower volatility and risk

Another study , focused on board diversity and firm risk— found that diverse boards experienced lower volatility and better performance.

The basic hypothesis of the study was simple:

Firms where the CEO is king (where the CEO has un-checked decision-making power) tend to make more idiosyncratic (quirky) decisions. Idiosyncratic choices tend to lead to more extreme outcomes, and therefore greater risk. Similarly, a homogeneous set of perspectives and biases on the board is likely to make decision-making more idiosyncratic, as decisions tend to attract less scrutiny within the board if most directors think alike.

The study used five metrics to define “diversity” — age, ethnicity, gender, educational background, financial expertise, and breadth of board experience — and found that board diversity had several effects:

1. Make more persistent decisions

The study found that corporate policies passed by diverse boards lasted longer than policies passed by more homogeneous boards. The authors mention that it’s possible that these “more persistent” policies might contribute to board diversity’s mitigating effect on volatility.

2. Rely less on debt capital and maintain greater dividend payouts

An increase in board diversity of one standard deviation was associated with an increase in dividend returns to shareholders of 1.1 standard deviations. An increase in board diversity was also associated with a reduction in both market and book financial leverage.

3. Invest more aggressively in R&D

Firms with more diversity in the study also invested more in R&D and had more efficient innovation processes. The researchers compared patent output to R&D expenses and found that higher diversity among directors was associated with more innovation output, “both in absolute terms as well as per dollar of R&D investment.”

They also found that firms with more diverse boards had more efficient innovation processes. The study found that total patent citations, citations per patent, and patent originality all increased with board diversity.

4. Reduce return volatility

The study concluded that “a one standard deviation increase in board diversity causes a 24-percentage point decrease in annual realized return volatility.” (emphasis mine) Diverse boards tend to adopt more conservative financial policies, which can reduce the risks that investors need to bear.

5. Lower Firm Risk

The authors found that all of the above points contribute to lower firm risk across the board. Robust decisions, conservative financial policies, efficient innovation processes, and less reliance on debt all contribute to reducing Firm Risk overall.

Potential drawbacks?

The study also acknowledged certain potential problems that could be caused by diverse boards. Researchers found that board diversity moderates firm risk less when market conditions are more volatile. They hypothesized that “nimbler decisions” might be more beneficial in volatile market conditions. If you need to make decisions faster, it reduces the benefit of having many different perspectives that might disagree.

They also recognized that low-risk taking, in certain circumstances, might actually be inefficient and neglect calculated risks that would benefit shareholders (though this was a hypothesis that the study did not attempt to address).

In addition, the firm risk study found a lower risk-mitigating effect when more directors are co-opted or have longer tenure. Essentially, board members who have been with a firm for too long risk falling into patterns of “groupthink” or defer too much to the CEO. That narrowing of the board’s perspective undermines the business case for having a diverse board.

Even so, the study concluded that “both operating performance and asset valuation multiples increase with board diversity.”

Higher ROE and EBIT Margins

Expanding beyond just board diversity, McKinsey looked at top-team diversity at 180 publicly traded companies in The United States, the United Kingdom, France, and Germany.

In looking at the top and bottom quartiles for board diversity, companies ranking in the top quartile of board diversity saw 50% higher ROEs were 50% on average, than for those in the bottom quartile. Meanwhile, EBIT margins at the most diverse companies were 14% higher, on average, than those of the least diverse companies.

(Very) slow progress

I think that inertia — rather than lack of evidence — is what’s keeping private equity from really leaning into fostering board diversity at portfolio companies. Broadening your network is difficult, and it can cost money when you employ a search firm or other means of accessing professionals outside your network.

For more on the “why haven’t more boards done this?” subject, check out Heidi Roizen’s excellent piece.

But private equity is in the business of finding and nurturing opportunities that others overlook. Diverse leadership, right now, is one of those opportunities, particularly among private companies. Diverse teams bring a variety life experiences that materially broaden a board’s scope of knowledge. They look at the world through a wider lens and may spot opportunities that relatively homogeneous teams wouldn’t, or predict risk that would otherwise go unnoticed.

Given private equity’s reputation for homogeneity, a pivot towards top team diversity will give early movers a relative advantage over laggards. Evidence of diversity’s benefits is spreading, and outside pressure to promote it is growing quickly. California has just passed a law that mandates board diversity for public companies headquartered there: the second such law in the last two years. Other states are considering their own requirements.

If you work in private equity or are on a private company board, I recommend that you strongly consider strategically implementing board diversity before it becomes the status quo (or a requirement), eliminating the relative advantage.

Full Disclosure: I freelance for an organization, BoardReady, that promotes board diversity. I’m always happy to discuss the data in more detail and to hear alternate perspectives. These types of conversations are critical as we move through the Coronavirus crisis and into the altered business landscape.

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