Podcast: Josh Lerner, Harvard Business School — Future of Diversity & Inclusion in Private Equity
As we consider the future of diversity and inclusion in private equity, can the industry meet the challenge?
To seek answers, the Private Capital Project at the Harvard Business School and the Private Capital Research Institute recently hosted a webinar with a group of limited and general partners. What did they find?
We spoke with one of the conference leaders, Dr. Josh Lerner, the Schiff Professor of Investment Banking at Harvard Business School. He co-directs the National Bureau of Economic Research’s Productivity, Innovation, and Entrepreneurship Program and serves as co- editor of their publication, Innovation Policy and the Economy. He founded and runs the Private Capital Research Institute, a nonprofit devoted to encouraging access to data and research, and has been a frequent leader of and participant in the World Economic Forum projects and events. He has been named one of the 100 most influential people in private equity over the past decade and one of the ten most influential academics in the institutional investing world.
Chris Riback: Why did you bring together this group for the discussion? What was your goal?
Josh Lerner: It really was two-fold, one of which is that I'm convinced that this is a topic that has really under-researched, that there's just so much more need to build understanding of this, of the issues here and that I was hoping that this would stimulate the academic work, but on the other hand, there's also just been enormous practical interest around this, that pensions, endowments and others are thinking about and grappling with these issues and sort of bringing together some thoughtful people who know the territory well, I thought it would be very helpful as well.
Chris Riback: So have you been getting questions and inquiries from the marketplace?
Josh Lerner: Well, we did a series of studies for the John and James Knight foundation, which essentially looked at diversity and diversely owned asset managers. So essentially saying when we look across various asset classes, from public to private and then within private from real estate to venture, to hedge funds and so forth. What do we end up seeing in terms of the role of firms that are diversely owned, whether women owned or minority owned and using various thresholds, but largely focusing on 50% plus ownership. So at the time that we originally did the work with Knight it got some attention, but not an extreme amount of tension. But really within the last six months, there's certainly been explosion of interest in this topic. And a lot of inquiries from people within the investment management world. Yes.
Chris Riback: And was your goal in bringing together the folks that you did was your goal to identify challenges and issues, or was it to find actual solutions?
Josh Lerner: A little bit of both that I think that certainly when you think about the work that we did with Knight, it documented the nature of the problem, but it really didn't either get into the root causes of those problems or with the best solutions would be. And clearly those are really first order problems. They're obviously very linked because without really understanding the root causes, it's hard to come up with solutions, but really wanted to advance the discussion around how to address the disparities. Certainly seen in the numbers that we put together.
Chris Riback: So let's start talking about some of the areas that you explored, what is the build the pipeline problem?
Josh Lerner: Well, essentially one way to think about it is that the way in which one gets a lot of diversity owned firms is that one that it's in some sense, no, from any other kind of new private equity groups, that in some sense, what you say, what is the most common way of getting a new private equity group or new real estate group, or even for that matter, a new public market group. It tends to be people who are working for the established groups, where the most established firms in the industry who spin out and start their own groups. Right? So,
Chris Riback: Yes.
Josh Lerner: If you were to look at private equity as example there's just been generations of people who have left the Bain's and general Atlantic of the world with great track records. And then that their success has ended up allowing them to go out and begin their own firms.
And in the same way when it comes to diversely owned firms we'd like to see that same process working yet historically when you look across the senior investment staff in many corners of investment management, it has been not a huge amount of women in not a huge amount of minorities. So in a way, the first challenge really is this building the pipeline of people within the large firms. Who with an eye towards the thought that some years, hence once they've developed a terrific track record that they might consider spinning out themselves.
Chris Riback: I was surprised I've got to say, to read your finding that, and I'm reading from your report now, hiring decisions are too often made by unseasoned junior associates who are less cognizant of the broader goals of the organization and less experienced in finding talented minorities. And then you continued that this change will require involvement of the most senior people at the organizations. It also may require a change in mindset, okay. Moving on there. So the junior versus senior, every organization I have ever had you've talked with studied research, I would assume the same is true for you. You're the one who does that for a living. We'll say number one, talent is what matters talent is our differential, it's the people. How could you have found that this type of hiring was being done by unseasoned junior associates?
Josh Lerner: Well, I just think that it's probably fair to say that rookie hiring, no matter what the field is, a lot of work, right? You have to go through a process of plowing through a lot of resumes. There's a lot of interviews, a lot of screening. Yes. It's just a laborious process. So it's not surprising that whether we're looking at investment banks or private equity groups, or for that matter academic institutions, there's a tendency on the part of the old guys sometimes to say, "You guys go and do it." Right? In some sense, the appeal of having young people do this is that they have the time and energy. And in many cases, they're close in age and can read between the lines in terms of people in a way that certainly seems appealing.
But I think the concern which was highlighted is that in many cases there's sort of a tendency on the part of young people, just nature the world to end up looking at and ending up hiring a bunch of people who are more or less like themselves. And if one's goal is to sort of dramatically improve the diversity of an organization, there's often a need to, what was the phrase the Apple use think different, right?
Chris Riback: Yes.
Josh Lerner: A little bit outside the normal pipeline, that's there and to really challenge some of the assumptions as to what makes a promising candidate and what are the, what are we really looking for? And I think it's that sort of ability to think different that is probably not what one's typically going to see among the, in a situation where a lot of the hiring decisions have been devolved to the younger generation, no matter how smart and ambitious they are.
Chris Riback: Are you finding within the industry a desire to think differently about HR and about hiring in general? Or have you not necessarily seen that yet and that's one of the reasons why you have this recommendation?
Josh Lerner: Well, I think that in a way there's a two-sided answer. I mean, so certainly today everyone's saying the right things to have paying attention to this issue, but I think if you were to look over, for instance, the history of investment banking and recruiting there've been a series of initiatives over the years where there's been a lot of attention paid to this issue and a lot of commitments made to focus for instance, on increasing minority hiring. And the like, but often it seems that these things there's initial wave of enthusiasm and then it just sort of Peters out. Right? And it goes back to the way that the world's always always been. So I think the question is not really about the short run and interest in the short run, but really more in terms of whether this time can be different in terms of a real long-term commitment to this kind of hiring and building the pipeline that's needed.
Chris Riback: In terms of the long term and in terms of thinking about this beyond just the short term requirements, that's where I would think investment starts to come in and rethinking the investment criteria and the role that the LPs can play. For LPs, they operate though under a defined set of investment criteria. Are those criteria properly defined to meet this moment and challenge?
Josh Lerner: I think it's a very interesting and important question. I think one thing that we shouldn't do is minimize the challenge that LPs face, that they've got a lot of money to put to work. There is a general temptation to say, "We want to write only a few big checks. We have a limited number of relationships," just simply because it's challenging to manage a whole bunch of smaller, a smaller set of ties. There's almost inevitably going to be a bit of a bias towards saying, "Let's go with the most established and seasoned groups out there." As I'm sure you've heard many times, there's that old saying about no one got fired for buying IBM. I think that a little bit of that carries over into the investment management world as well, saying that choosing some of the most established and safe names is in some sense a no lose strategy.
I think certainly one of the challenges that many diversely-owned firms face is that they're smaller. They're younger, so less of a track record. So as result, even if they're potentially very attractive, for instance just to raise one criteria, they may be profoundly differentiated in terms of looking at market segments and having networks that majority-owned firms are going to find very difficult to penetrate. At the same time, they're going to be difficult to fit in using the standard plain vanilla criterion that a large pension fund might use.
Chris Riback: So what guidance do you give LPs? I'm sure you are sensitive to the challenge. They, I'm sure, would argue simultaneously that yes, absolutely, they want to support in any way possible diverse GPs and diverse opportunities. At the same time, what they must do is be absolutely blind to that because what their responsibility is in terms of a return on their investment and to look at every investment based on the financial factors. How do you encourage or persuade a balance? Is there a market case for what you're arguing?
Josh Lerner: Yes. So first of all, it's important to re-emphasize that there really isn't a trade-off here, that certainly the work we did looking across a wide variety of asset classes found that diversely-owned firms, whether in private equity or real estate or so forth, did as well, statistically indistinguishably different from the majority-owned firms. So it's not like we live in a world where there is essentially some sort of expectation that because one has a diversely-owned firm, there's going to be one he has to accept by definition some lower performance as a result. That being said, clearly there needs to be, in some cases, a broadening of the criterion.
So just let's think about size, for instance. Many of the diversely-owned groups are smaller because they've been around not as long and haven't broken into the firmament of mega funds. But that being said, there's nothing written in stone that pension funds, for instance, have to put all their money with very large managers. What the conversation highlighted is really saying, "Let's, without posing this false dichotomy of diversity versus performance, well, try to think about where are the stumbling blocks that lead asset owners to say, no, even if there is a very promising diversely-owned group?"
Chris Riback: What's the role for activism in generating change here?
Josh Lerner: Well, I think that's a very interesting question, which has got a bunch of different sides to it. Certainly there've been a number of concerted efforts in the last year or two to try to highlight the fact that diversely-owned managers represent a small part of institutional ownership. And in some sense, I think it's hard not to respect that effort. As one of our panelists pointed out, there's been a long history of people saying stuff in the United States about why minorities can't have this or can't have that. And largely, they've not changed their mind on their own accord, but they have responded to external pressure.
At the same time, there is... I'm cautious about a problem that I sometimes call the intolerance of failure. One of the things that we saw looking in depth at private equity and private equity investments by institutional investors in the last several decades, is that it seems that diversely-owned firms have been treated differently from majority-owned firms when it comes to how under performance is treated. In particular, it seems that diversely-owned firms are punished much more severely for under performance in terms of being either unable to raise the follow on fund or just simply getting their fund size dialed down very dramatically in a way that many majority-owned firms haven't. In some sense, we know that part of the investment business is under performance, that even if we think about some of the great names in various asset classes, they almost all went through some period where they had a rough patch and had some disappointing returns. And in many cases their investors stuck with them and allowed them to work their way out of the woods and right the ship and all that.
In a way, it's hard not to think that a little bit of the intolerance of failure problem stems from asset owners who went along with investing in a diversely-owned fund, but weren't really committed to it and then were far more unforgiving of a little stumble than they would have been of a majority-owned firm. So in a way there's a bit of a balancing act there, but certainly I guess my feeling is that anything we can do to very much encourage attention to this issue and to highlight the potential in diversely-owned firms is going to be positive by and large.
Chris Riback: So that's exactly what I wanted to ask you was, so how do you get the word out? The intolerance of failure dichotomy that you just described. The fact that the return on investment from diversely-owned firms is the same, the data that you talked about earlier in the research that you have done, the importance of changing the filling-the-pipeline process and getting senior managers more engaged, how do you get word out on that message?
Josh Lerner: It's a great question, Chris. I think there's a couple areas that I would highlight. One is that I think there is need for continuing data that in some sense, we know that old saying about how you can't manage what you don't measure. Our work with Knight was an initial effort to try to measure some of this stuff, but keeping up the measurement and having dashboards and understanding what is happening with the industry, I think is an important aspect. Beyond that, I think there's also a real need for best practices, that when you look across the industry you see that there are some asset owners who seem to have been quite successful in getting their funds in the hands of diversely-owned managers and really doing well with it.
There've been others who've been quite successful in encouraging their GPs to pay serious attention to this issue. I think that one of the things that really behooves us as academics is to capture some of the best practices that are out there in terms of building diversity in the industry and really highlight the nuts and bolts of what they did so that these things can be more widely emulated throughout the industry.
Chris Riback: And is that work that you're doing? Or is that a nugget that you're putting out there hoping that another big fish like you will come along and take a bite and carry things forward?
Josh Lerner: Well, we're taking a stab at it ourselves, but I think that this is a big issue with a lot of aspects to it. So hopefully some of my colleagues will get excited about this area as well.
Chris Riback: Why are you doing it, just to close out? You've got limited, we all have limited time. There are a lot of different areas that you could and should be researching. Why for you personally, are you devoting time, energy to this topic?
Josh Lerner: The patterns that we see in data are just really striking in terms of... And when you think about financial intermediation, obviously venture and PE and real estate are great examples of this, there's really two aspects that make having diversity really important. One, of course, is just simply wealth creation. We know that owning asset management firms has been a route to wealth creation. And in as much as we're concerned about the uneven distribution of wealth in this country, I think anything that can be done to encourage wealth creation in the minority communities especially, is going to be a strong, positive aspect.
But the other aspect is something which the academics sometimes call homophily, by which they mean that people tend to fund other people who are like themselves. And in a way, if we're really interested in trying to boost, for instance, entrepreneurship and new ventures in the minority communities, having a bunch of diversely-owned, well-capitalized investment managers is I think, in many senses, a really important piece of the puzzle. So in a way, when we think about these intermediaries, this is really high-powered money. It can really have second order effects, which can really impact society in a very broad kind of way.
Chris Riback: Well, it's high-powered money. It's also high-powered work and it's high-powered importance. So thank you, Josh. Thank you for your time and thank you for the work that you've done.
Josh Lerner: Really enjoyed having a chance to talk. Thanks again.