Can VCs Turn New Focus on Race and Inequality Into Long-Term Impact?

Morgan Stanley’s second annual survey of venture capitalists reveals the intensified dialogue around racial inequality has captured investor attention and shifted their attitudes significantly. The increased focus on this issue is leading to investment strategies that include more actions to address disparities in funding for multicultural- and women-founded companies, which are well-documented for women and Black entreprenuers.¹

Our survey research illustrates:

1. The discourse around race and inequality is raising awareness of the funding gap that multicultural entrepreneurs face and the opportunity they represent, motivating VCs to close that gap. VCs better understand and value the opportunity that multicultural-founded companies present and have made it a priority to invest in multicultural entrepreneurs.

• 61% of VCs say that the Black Lives Matter (BLM) movement has affected their investment strategy.
• 43% of VCs say that finding opportunities with multicultural-founded companies is a “top priority” for their firm, a 10-percentage-point increase from 2019.
• 75% of VCs strongly agree that “it is possible to have an investment strategy that intentionally invests in women and multicultural entrepreneurs, while still maximizing returns,” up from 55% in 2019.
• In what could be a breakthrough, more than two thirds of VCs we surveyed (68%) say that they are more likely to invest in multicultural-founded companies in the coming year.

2. VCs are taking important initial steps to implement changes around increasing diversity and are discussing additional ways to help close the funding gap. While systemic change won’t happen overnight, VCs have started making changes to increase the diversity of the companies they evaluate and are actively considering other measures. To help close the funding gap, more VCs say that they are providing constructive feedback more often to help entrepreneurs strengthen their pitch (82%, up from 69% in 2019), proactively expanding their network (80%), and attending conferences, events, or demo days focused on women or multicultural entrepreneurs (75%).

3. Diverse investors drive early signs of progress. While showing some improvement since last year, traditional VCs² are still less likely than women or multicultural VCs to see the value of investing in companies founded by diverse entrepreneurs. Only 59% of traditional VCs, compared to 83% and 84% of women and multicultural VCs, respectively, believe that it is possible to have an investment strategy that intentionally invests in women and multicultural entrepreneurs while still maximizing returns.

4. VCs aren’t feeling pressure from their LPs to prioritize diverse entrepreneurs. A plethora of data-backed evidence shows that investments in women and multicultural entrepreneurs yield above-market returns.^{3, 4} LPs, who hold significant influence in investment decision-making in the VC ecosystem, can maximize risk-adjusted returns and shift industry priorities by investing in more diverse entrepreneurs. However, VCs have not yet marked a major change on this issue—only 59% of VCs believe that investing in diverse entrepreneurs is a priority to their LPs, up slightly from 55% in 2019. 

5. VCs have significant leeway to define their accountability for existing portfolio companies. They can play an instrumental role in addressing inequality and ensuring sustainable progress by focusing on existing portfolio companies in addition to diversifying new opportunities. Twelve percent of VCs say that their firm is willing to reduce its investment in a portfolio company because it is insufficiently diverse, and 36% say their firm holds their portfolio companies accountable for achieving and maintaining diversity.

This year, more VC firms assigned greater value to the investment opportunity that multicultural-founded companies present, and say that they are more likely to invest in multicultural and women-founded companies in the coming year.

The national discourse around systemic racism and the demand for racial equity in America appears to have shifted VCs’ attitudes toward investing in multicultural-founded companies. More than 3-in-5 (61%) VCs say that the Black Lives Matter movement has affected their investment strategy. This positive shift in VC attitudes and actions is considerable. In 2019, 12% of VCs surveyed said that the racial diversity of their portfolio company founders was not an important factor in their investment decisions. Today, VCs unanimously acknowledge the importance of racial diversity among their portfolio companies’ founders.

VCs recognize that multicultural-founded companies are at a structural disadvantage when it comes to funding and are badly underrepresented in their own portfolios. VCs are most likely to say that there are too few Black entrepreneurs (80%) and multicultural entrepreneurs (72%), compared to women entrepreneurs (58%). VCs’ satisfaction with their own portfolio reflects the same dynamic: Just 17% say they are satisfied with the rate at which they invest in multicultural-founded companies, while 36% are satisfied with the rate in which they invest in women-founded companies. While VCs plan to diversify in many ways, the visible underrepresentation and heightened dissatisfaction with their underinvestment in multicultural-founded companies could mean a more targeted focus on multicultural-founded companies moving forward. In what could be a breakthrough, more than two thirds of VCs we surveyed (68%) say that they are more likely to invest in multicultural-founded companies in the coming year.

Additionally, VC firms’ priorities are now catching up with individual investors’ priorities in this area. Of those surveyed, 45% say that finding opportunities with multicultural entrepreneurs is a personal priority (about the same as last year) and, in a 10-percentage-point increase from last year, 43% of VCs say that finding opportunities with multicultural entrepreneurs is a top priority for their firm as well. Closing this gap is especially important, with more than 90% of VCs agreeing that fund managers have a responsibility to their clients to actively explore investing in women- and multicultural-founded companies. 

Moreover, this year marked a sharp increase among those who strongly agree that “it is possible to have an investment strategy that intentionally invests in women and multicultural entrepreneurs, while still maximizing returns,” from 55% in 2019 to 75% in 2020.

More VCs now track the financial returns of multicultural-founded companies in their portfolio, something we advocated for in our 2018 survey report. This year, 59% are aware of the performance of their multicultural-founded portfolio companies, up from 47% in 2019. Notably, almost all VCs who track such returns say that multicultural-founded company returns are performing on, or above, average, relative to their entire portfolio, mirroring research showing that companies with diversity in senior leadership can often generate higher profitability.⁵

VCs are taking important initial steps to implement changes around increasing diversity and are discussing ways to make additional changes that will help close the funding gap.

Among those who consider diversity a top priority, nearly all respondents (92%) say that their VC firm has publicly disclosed diversity as an investment priority. But saying so publicly is not enough—acting on their promises starts with internal discussions on how to increase the diversity of the founders in their portfolios and implementing their strategy, which is exactly what VCs are reporting.

The number of VC firms saying that they internally share statistics on the number of women- or multicultural-founded companies they evaluate and invest in has sharply increased—to 64%, from 48% in 2019—suggesting a higher level of self-accountability. 

Traditional VCs are less likely to prioritize or take action toward investing in multicultural-founded companies when compared to women or multicultural VCs.

While we have observed a shift in attitudes and actions to address racial inequality in the VC space in the past year, that shift hasn’t prevailed among white men, who make up the majority of the VC industry.⁶

Our survey found clear indications that traditional VCs actively think about racial diversity among their portfolio company founders: 59% say BLM has affected their investment strategy and only 17% expressed satisfaction with the number of multicultural entrepreneurs in their portfolios. Traditional VCs’ attitudes have shifted toward more inclusivity in the past year, but a gap still exists between them and women and multicultural VCs. Traditional VCs are much less likely to believe that it is possible to maximize profits by investing in diverse entrepreneurs, and they are less likely to have taken actions to address racial representation among their portfolio company founders.

Compared to women and multicultural VCs, traditional VCs are less likely to believe that they can have profitable investment strategies that emphasize diverse entrepreneurs, and they are less likely to have taken action.

Traditional VCs’ reasons for not investing in multicultural entrepreneurs shifted this year. Last year, 27% of traditional VCs said that multicultural companies are “not the right fit for me”—a ratio that fell to 12% this year, suggesting that the national conversation around racial justice and diversity may have encouraged more of them to “get out of their comfort zone” and explore once unfamiliar sectors, markets and opportunities. As we reported last year, companies and products founded by women and multicultural entrepreneurs that address a market inefficiency or need, based on their personal experiences, fall exactly into the categories of calculated expansion risks that VCs should be considering.

However, gaining exposure to diverse entrepreneurs remains a significant challenge for traditional VCs. The perception that there are “not enough multicultural entrepreneurs” or that they “can’t find multicultural entrepreneurs and/or don’t have the relationships” remains a consistent theme among traditional VCs vs. women and multicultural VCs. Indeed, we found minimal progress in traditional VCs’ efforts to increase their exposure and take active measures to expand their network (“not enough” was 60% in 2019 and is 65% in 2020; “can’t find” was 33% in 2019 and is 47% in 2020). Still, the shift in mindset marks an important first step. 

LPs inhabit a unique position to encourage VCs to invest in more diverse-founded companies. The past year has seen only a modest increase in VCs’ perception that investing in companies with women and/or multicultural entrepreneurs is a priority to their LPs, from 55% in 2019 to 59% in 2020. To change investing behavior, LPs must fully and openly embrace the importance and financial benefits of investing in more women- and multicultural-founded companies. Equally important, LPs who feel strongly about making diversity a priority should convey that expectation to their VCs and consider setting concrete targets for investing in women- and multicultural-founded companies. 

VCs can play a greater role in addressing inequality by implementing accountability practices with their existing portfolio companies. To address racial inequality, VCs can start with their existing investments. Among those surveyed, 80% say that it is important for a portfolio company to share publicly the gender and racial/ethnic diversity of their partners, board of directors or C-suite. However, 64% of VCs are either unwilling to hold a portfolio company accountable for failing to do so, or are unsure whether their firm would be willing to act. Only 12% say that their firm is willing to reduce its investment in a portfolio company for insufficient diversity; even fewer (4%) say that their organization would be willing to stop working with a portfolio company due to lack of diversity.

We are encouraged by this year’s data, but to ensure that good intentions translate into real change, we need to be diligent about holding ourselves—and each other—accountable. To help VCs boost diversity and access returns from a widely untapped pool of multicultural and women entrepreneurs, Morgan Stanley has developed a playbook for VCs to seize these opportunities and put their capital to work:

• Take steps to expand your network.
• Set active diversity targets with realistic, sustainable goals.
• Share research on the business case for investing in women and multicultural entrepreneurs and continue tracking financial returns for women- and multicultural-led portfolio companies.
• Publicly release your firm’s diversity metrics to measure your progress, but don’t get complacent with progress.
• Hold portfolio companies accountable in meaningful ways.
• Diversify your own firm, which will invite new perspectives and connections with more diverse entrepreneurs, thereby improving results for your LPs.

In the coming years, it will be critical to understand if the attitudinal shifts and intentions observed this year translate into measurable progress. Transparency is the tactic that will lead to true change. To help VCs assess their progress, Morgan Stanley plans to revisit key metrics that will reveal whether the industry has improved measurably, including:

Methodology

This report is based on a survey conducted on behalf of Morgan Stanley by Brunswick Group between August 5 and 8, 2020, in the U.S. The survey was conducted online among 76 venture capitalists who are almost exclusively leads or co-investors, with an average equity check size of $2.65 million. The VCs who were invited to participate in the survey were provided by Morgan Stanley.

The profiles of the survey respondents were as follows:

• Traditional (white men): 22%
• White women: 29%
• Multicultural men: 17%
• Multicultural women: 25%
• Declined to answer: 7%

The definition of “multicultural” that was provided to respondents in the survey was “Black/African-American, Hispanic/Latino, Asian, and all other nonwhite persons.”