FINANCE TODAY | ISSUE NO.30
A CULTURAL SHIFT TOWARDS DIVERSITY, EQUITY AND INCLUSION
2020 was a year that redefined the term disruption. Business disruption typically refers to any innovation within an industry that changes the way all companies in that industry continue to function. Last year frankly demonstrated how disruption could be caused via sources external to the industry. COVID-19 changed the way billions of people work and live their daily lives, regardless of their industry. Additionally, events such as the death of George Floyd in May last year brought issues of systemic racism to the spotlight alongside the already daunting challenges introduced by COVID-19. This ultimately led to calls for increased racial equity. Challenges posed by the virus were handled promptly, and racial equity challenges were given less priority.
Research from Mckinsey & Company on diversity across industries shows that companies with greater diversity in leadership ranks are more likely than those with less diverse leadership to perform better than the industry average on margin growth (Baboolall, Nee, & Yee, 2021). When applied to private equity (PE) firms, their analysis shows that private equity firms, in particular, can respond to these challenges and improve diversity, equity, and inclusion (DE&I) in the workplace, ultimately leading to increased opportunity for financial outperformance.
THE OPPORTUNITY IN PLACE FOR PE FIRMS
Before continuing, it is beneficial to define private equity briefly. Private equity refers to ownership of an entity that is not publicly traded, an example being ownership of a private company. PE firms and their portfolio companies have ample opportunity to influence the status quo of the business due to their sheer size. Globally, about 10,000 PE firms have more than US$3.9 trillion in assets under management (AUM). In North America alone, nearly 4,700 firms own more than 18,800 companies (Baboolall, Nee, & Yee, 2021). Research from McKinsey and Company’s report, Women in the Workplace 2020, shows that PE firms lag behind corporate America on gender and diversity in senior ranks. Below is a stacked bar chart demonstrating the level of diversity at each career stage.
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The level of diversity is lowest at the board level, where 80% of PE employees at this stage are made up of white males. Diversity is highest at the entry-level, where the workforce is almost equally composed of white and non-white women. White men slightly outnumber men of colour at the entry-level. PE firms perform fine at lower levels of the hierarchy, therefore the primary area for improvement in diversity lies at the management and board level.
HOW CAN PE FIRMS CATALYZE DE&I ADVANCEMENTS?
Through their research on the strengthening business case for gender and ethnic diversity, McKinsey has discovered that companies in the top quartile for gender diversity were 25% more likely to outperform industry-median EBIT growth than bottom-quartile companies. Similarly, executive teams in the top quartile of ethnic diversity were 36% more likely to financially outperform the industry median (Baboolall, Nee, & Yee, 2021). Assuming this case holds true for PE firms, this provides substantial evidence to argue that PE firms that focus on diversity across their portfolio would experience a significant increase in value.
McKinsey outlines several actions PE firms can take to promote DE&I at the management level as well as within their portfolio companies. These actions include:
- Make A Public Commitment – Firms could build a council focused on DE&I. The council could develop metrics and goals for the purpose of monitoring progress on targets for both the firm and the portfolio
- Conduct Diversity Assessments of Targets – PE firms could make diversity a larger component of their criteria when looking at targets for acquisition. Building DE&I criteria into due diligence of targets and investment-committee reviews can help not only to assess risk but also to understand the value-creation opportunity inherent from improving DE&I (Baboolall, Nee, & Yee, 2021).
- Focus on Diversity Performance – Firms could create incentives for increased diversity performance (Ex. Additional compensation for exceeding expectations for specific DE&I metrics).
- Set Diversity Targets for Boards – PE firms have seats on the boards of most of their investments. They can either fill those seats with qualified, diverse candidates or add new seats to build a diverse board of directors.
- Establish Diverse Management Teams – PE firms can make changes to the workforce of each portfolio company to simultaneously increase diversity and performance
- Remove Structural Racism from All Corporate Policies Portfolio-Wide – Firms can examine current benefits and corporate policies and restructure them to promote equity in advancement of underrepresented minorities (Baboolall, Nee, & Yee, 2021).
Overall, PE firms possess an opportunity to change the current landscape of the business world and further promote diversity within the workplace. Many PE firms are already moving ahead with the opportunity and implementing DE&I into their daily practices. Realistically, it won’t be long before institutional investors and other players in the financial industry begin to follow suit.
Baboolall, D., Nee, A., & Yee, L. (2021, March 02). How private equity can catalyze diversity, equity, and inclusion in the workplace. Retrieved March 03, 2021, from https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/how-private-equity-can-catalyze-diversity-equity-and-inclusion-in-the-workplace