Morgan Stanley: VCs Neglect Women and Minorities, and It's Hurting Returns

Women and multicultural entrepreneurs represent a huge investment opportunity, something to which U.S. venture capital firms give lip service. But most VCs do not actively pursue investments in such firms, according to a new study by Morgan Stanley.

As a result, VCs are leaving money on the table and hurting returns.

The Brunswick Group, a business consultancy, conducted two surveys in the U.S. between Aug. 19 and Sept. 13: one of 58 venture capitalists with an average equity check of $9.4 million; and one of 141 female or multicultural founders who had raised VC funding for at least one of their businesses (91% of participants had raised at least $1 million in venture capital).

The surveys defined multicultural as "Black/African-American, Hispanic/Latino, Asian and all other nonwhite persons."

Sixty percent of the VCs said their portfolios held too few companies founded by women and multicultural entrepreneurs, and 83% said they could prioritize investment in such companies and maximize returns.

However, three in five VCs reported that diversifying their portfolios was not a firmwide priority. Of the white male venture capitalists in the survey (a quarter of the sample), only 33% said they prioritized companies founded by women, and just 13% did so in companies with multicultural founders.

According to the report, even investors who said they sought to invest in diverse entrepreneurs used outdated methods that could be holding them back: 96% sourced investment opportunities "directly from my own network," and 89% used "warm introductions/referrals from someone I know."

Possibly as a result, half of male VCs believed that there were not enough female entrepreneurs, and two in five said the same about multicultural ones.

The report said that diversifying investment professionals could help firms improve their exposure to women and multicultural entrepreneurs.

Among those that said they had hired more diverse fund managers, limited partners, partners or board members, 71% said this was a very effective way to diversify their portfolios.

In addition, female VCs were much likelier than their male counter parts to have made a point of diversifying their portfolios. And two-thirds of multicultural founders said they had had more success with diverse VC firms.

Still, only 11% of entrepreneurs in the survey said they had interacted with VC firms that had gender and racial diversity.

The report cited a study by AllRaise that said 29% of VC firms have at least one female partner, while another study found that 3% of investment professionals are black and 1% Latino.

The Right 'Fit'

The report noted that VCs have consistently made big bets, frequently with no precedent or data other than their conviction that those investments would succeed.

But when it comes to investing in companies with diverse founders, VCs often pull back because those companies are not the right "fit."

The survey results suggest that compared with other new investment opportunities, VCs are less inclined to explore how diverse businesses could be the right fit for their fund, or be opportunities to take calculated expansion risks.

According to the report, the "fit" concept can change as VCs look for investment opportunities outside their traditional criteria, and aggressively pursue these by educating themselves and consulting outside experts to advise them on products or companies beyond their investment criteria.

For example, VCs in the survey cited expansion risk (defined as investing in a new product, market or geography outside a firm's typical investments) as the chief risk they were willing to accept to maximize returns. On average, 19% of the sample said their portfolios represented an expansion or divergence from their typical investments.

The report asserted that companies and products founded by diverse entrepreneurs that address a market inefficiency or need, which they have identified based on their personal experiences, are the kinds of calculated expansion risks VC should be considering.

Eighty-eight percent of VCs surveyed saw underrepresented entrepreneurs' lived experiences as a competitive advantage in identifying problems awaiting solutions or markets to be addressed.

Yet, Morgan Stanley said its research suggested that VCs are unlikely to educate themselves on the market segment, product or opportunity — particularly when the customer or product is not one with which they are familiar.

Missed Opportunity

The survey found that 45% of VCs did not know how the returns from companies founded by women compared with their overall portfolio returns — this from famously data-driven outfits. And 53% said they were uncertain about the returns of companies with multicultural founders.

VCs might consider this finding from a 2018 Boston Consulting Group study of 350 startups in the Boston area, cited in the report: Although women on average raised less than half as much as their male counterparts, they earned 78 cents per dollar invested, versus 31 cents for the men.

The Morgan Stanley report also pointed to what it called a prominent seed-stage VC firm that found that teams with at least one female founder did 63% better than all-male founder teams from the perspective of change in valuation since the initial investment.

In addition, the report noted, companies that serve diverse customers represent a big opportunity to capitalize on consumer segments with a lot of room for further growth.

For example, women drive 83% of all U.S. consumption through both buying power and influence; African Americans spend $1.2 trillion annually in the U.S.; and Latino consumers' buying power is predicted to reach $1.7 trillion by next year.

Morgan Stanley said it has developed a playbook to help VCs access returns for their limited partners from diverse entrepreneurs:

Redefine how you think about "fit" and expansion risk for your portfolio
Diversify
Hold your firm accountable and be a first mover — institutional investors can help.

— Check out Industry's Gender Problem Is Bigger Than Ken Fisher: Krawcheck on ThinkAdvisor.