Amid the social justice movement in 2020, America’s innovation community sought to make progress on the immense disadvantages endured by underrepresented entrepreneurs. While venture firms and the investors that back them have taken some steps – and good intentions abound – a troubling subtext has emerged, which I call “Like Funds Like.”
One of the most important efforts of the past year has focused on empowering more underrepresented VCs. LPs of all sizes, from family offices to massive institutions, are setting aside (sometimes) meaningful allocations for minority fund managers. I celebrate the rapidly increasing numbers of female, Black, Latinx, LGBTQ, and other underrepresented VCs joining the ranks. This has been a homogenous industry, so this welcome change is long overdue.
But embedded in this otherwise inspiring trend is a subtle assumption that these managers will naturally focus on funding folks who look like them. This is a dangerous logic that, taken to the next step, suggests that funding more underrepresented VCs should be sufficient to “take care” of the dramatic funding inequities that plague female and minority entrepreneurs, and thereby let the rest of the sector off the hook.
This is particularly upsetting because most of these underrepresented VCs are managing so-called microfunds that are a fraction of the size of the larger, legacy players in the space.
Meanwhile, I have heard more than once the deep, real frustration from an underrepresented founder upon being rejected by a VC of their same gender or race. Again, the subtext here is that there are so few chances for that entrepreneur to get funding that the VCs that look like them ought to invest simply out of solidarity.
Ultimately, this phenomenon risks segregating our sector. It is too simple and too short-sighted to think that the only way to get money to minority founders is for there to be more minority VCs. This is old pattern-based thinking that fundamentally misses the point and power of diversity.
Put another way, we must not allow the important step of diversifying the VC community to absolve the industry at large from embracing diversity as the powerful investment thesis and moral imperative that it is.
Need a better strategy
Here’s a basic fact: we need a much more diverse sector, including more underrepresented founders and more underrepresented VCs, all creating and funding companies that solve problems for all sorts of populations. The percentage of VCs from underrepresented populations is embarrassingly low, matched only by how abysmal funding is for female founders (2.3 percent of all dollars) and founders of color (3 percent). By the way, for all the noise in 2020, the funding numbers actually got worse.
In fact, many have linked these two phenomena, positing that, for example, Black founders get too little funding mainly because Black VCs are too rare, too junior, or managing too few assets. After all, underrepresented VCs have deeper sourcing networks among their communities, they can set entrepreneurs more at ease in pitch situations and they are more likely to find points of shared experience that underlie so much of investment decision-making.
This speaks to one of the deep foundational mythologies of venture capital. Pattern recognition has long been an axiom of venture investing, perpetuating an unfortunate habit of VCs funding the people who look like them and the ideas that speak to their own experience. Put simply, VCs and the LPs that fuel them fall easily into habits that remind them of their past successes. It’s only natural that folks would extend this logic to say, ”Well, of course underrepresented VCs will support people who look like them and come from their experience.”
But this “Like Funds Like” phenomenon is troubling in a number of ways. First, this assumption clips the wings of underrepresented VCs, whose pipelines may indeed be more diverse, but many of whom wish to generate returns and value for society in an unconstrained, thesis-based strategy. Second, it subtly absolves legacy (more homogenous) VCs from focusing on the diversification of their own pipelines and portfolios, allowing the old pattern recognition methods to rule.
This is a huge problem, because – make no mistake – the vast majority of assets are still controlled by white men. The lifecycles of VC funds (and thus the creation of track records that attract really big LPs) suggest that it will be a long time before diverse managers control a truly representative, powerful portion of the dollars. Our entire industry as a whole should be striving for more diversity now, precisely because these timelines are too long.
By the way, my point here isn’t to discount underrepresented managers who choose to focus on elevating folks who share their particular background, gender or ethnicity. Rather, the issue is the expectation that they will do mostly or mainly that, and thus relieve the rest of the legacy sector of responsibility for diversity. It should not be expected that a Black VC will have a mostly Black portfolio, nor should it be surprising that a female VC chooses to invest beyond female founders.
In the words of Gayle Jennings-O’Byrne, co-founder of the WOCstar Fund, “We are actively going after a ‘female arbitrage’ that exists in the marketplace by investing in women of color tech start-ups, but the bigger reality is that diversity amongst funders, founders, and the whole industry is a smart investment for everyone’s bottom line.”
Indeed, if we are truly devoted to diversity, we need to ensure – right now, as money is finally starting to flow – that underrepresented VCs are not pressured into a pre-defined investment pattern, but encouraged to invest as they see fit. Equally, we should aspire to minority entrepreneurs having a real shot at funding from whichever firm they might pitch, no matter who the VCs are.
True diversity’s value proposition
Is this just about what’s right, or is there an economic case for this, too? After all, the innovation sector is one of the core strengths of the American experiment, and we have a responsibility to embody the principles of our society, but also to create great businesses and make money for investors. Either aim without the other is rather pointless.
Thankfully, recent research from McKinsey “demonstrates that the business case for ethnic diversity in top teams is stronger than ever.” The same holds true for gender diversity. According to the report, ethnically diverse teams are 36 percent more likely to outperform non-diverse teams, while 25 percent gender diverse teams are likely to financially outperform. This data holds true for VC portfolios with diverse founders.
Along the same lines, economist Paul Gompers shared his research on a causal relationship between diversity and financial performance in the venture capital industry in a 2018 article in Harvard Business Review. Dr. Gompers notes that the “goal of every venture capital investor is to choose . companies that will yield the best possible outcomes.” He found that “diversity significantly improves financial performance on measures such as profitable investments at the individual portfolio-company level and overall fund returns.” Homogenous partnerships tend to lower the performance of an investment, which is important. Even more crucially, diverse teams picking diverse portfolios outperform homogenous teams of a certain type picking homogenous portfolios of that same type.
How diversity goes sectorwide
As a sector, VCs and LPs need to recognize that diversity is not only a social justice imperative, but a high-performing, non-concessionary investment thesis. There are a few things we can do about this. First, LPs should ensure that even their existing VC investor relationships – not just the new “diverse” investments they are now making – are held to a high standard of inclusive investing. This goes for LPs funding the next fund in longstanding relationships, as well as those funding emerging managers of any background – having diverse portfolios and teams should be a meaningful part of the due diligence.
Second, VCs need to break pattern recognition norms, both by actively rejecting simple look-alike models of screening and also by diversifying their own teams. “If VCs really want to find phenomenal companies,” says chief operating officer of Tembo Health Tanya Perkins, “they should task everyone with rethinking every aspect of their deal funnel and portfolio support structures. Now that could really move the needle on diversity and fund performance.”
Finally, VCs should ensure that we are bringing each other into diverse syndicates to fund great entrepreneurs of all kinds. “Deals are often shared within circles of VCs from the same backgrounds – usually well-to-do white men,” says Stefanie Thomas of Impact America Fund. “Breaking down the racial barriers on cap tables will start to break down the network barriers that determine who gets funded and who does not.”
The bottom line
Traditional pattern-based investing – by VCs and LPs – has long overlooked investors and entrepreneurs who come from underrepresented backgrounds, colors, genders and geographies. We need everyone in our sector, from the most massive LPs to the newest entrepreneur to understand the power of diversity and embrace it at every level. Our sector will be morally stronger and economically more successful if diverse VCs are making great investment decisions into diverse portfolios, and diverse founders being funded by all kinds of investors.
So let’s make sure that underrepresented VCs have the freedom to invest as they wish, let’s make sure that they have real – not just symbolic – assets under management, and let’s make sure that our entire sector is seeking to fund diverse entrepreneurs, employ diverse teams, and even have diverse LPs fueling our funds.
To get the most out of this important moment in history – and our vibrant innovation economy – we must aspire to more: more diverse managers, more diverse founders, more diverse companies, and, therefore, more success.