In the last few months, we’ve seen much of Silicon Valley finally start to acknowledge generations of systemic racial inequity and take actionable steps to empower and support underrepresented people in tech. Funds are looking to invest capital more equitably and have started to take concrete steps to achieve this goal.
For example, Eniac Ventures and Hustle Fund have started to meet with more Black founders via consultations and encouraging cold inbound pitches. Initiatives like venture capital fellowships run by Susa Ventures and Unshackled Ventures will allow for increased representation in investment teams. While these initiatives are exciting, it’s important to explore how we can enable sustainable change and solve the diversity problem at the root.
It’s as simple as this: Investing in diverse perspectives makes for a far more efficient economy. The data also confirms this, given that homogeneous investing teams had a success rate for M&A and IPOs that was 26.4%-32.2% lower. Data since 1990 shows that approximately only 8% of VCs identify as women, with 2% of VCs identifying as Latinx and less than 1% identifying as Black.
It’s clear that the inequitable deployment of capital that results from homogenous investment teams at VC funds has translated into missed opportunity for outsized financial returns. Since this really comes down to how venture funds operate at their core, an entity that can greatly influence this and reinvent the status quo are VC funds’ limited partners.
Limited partners are the often unheard of backers of venture capital funds. Institutional venture capital funds raise money from sources such as high-net-worth individuals (HNWs), endowments, foundations, fund of funds, banks, insurance/pension funds and sovereign wealth funds that they will in turn use to invest money into high-growth, category-defining startups (the part that you do hear about).
LPs hold a lot of power in the venture financing life cycle as institutional venture capital firms can’t write checks at the scale they do without the external financing that LPs provide. Since LPs are the source of capital, they can control who they invest in (GPs) and how they invest and manage their capital. What if LPs are the missing link who can control the flow of capital to GPs who empower, find and fund more underrepresented entrepreneurs and keep them accountable?
That sounds great, but why does this matter?
The relationship between a general partner of a fund (GP) and an LP is predicated on the GP’s ability to generate outsized financial returns and return a multiple on invested capital. Because of this, an LP’s decision on which VC to entrust with their money is driven by, plainly put, who can make the LP the most money. This is neither good nor bad — but rather, something that is critical to the success of the innovation ecosystem as a whole.
We actually need LPs to be financially motivated so VCs invest their capital and resources in the best startups that have the potential to become category-defining companies that drive the innovation engine forward.
In this vein, LPs can be massively helpful in helping to bridge the lack of access to capital and resources for underrepresented founders as they build massive companies. They can help validate that funding more underrepresented founders is a smart business decision that leads to outsized financial returns. There are a few ways LPs can accomplish this.
Investing in more diverse fund managers
We’re at a really interesting inflection point in the tech world where meaningful change for underrepresented and underestimated minorities seems more possible now than ever before. Capital raising has long been a network game — those who have access to the right networks are those who raise large financing rounds from top firms that eventually lead to large exits. For the innovation ecosystem and our economy at large to function efficiently, access to capital needs to get democratized.
That starts with the top of the chain — where LPs invest in more diverse fund managers who in turn will invest in more diverse founders. These diverse founders are uniquely positioned to leverage their lived experiences to solve the problems of the world at large rather than those of a select few. LPs can find emerging fund managers that may be outside of their networks in various ways:
- By getting plugged into “tech Twitter,” where many emerging fund managers hang out.
- Cold outreach to rising emerging GPs that have been getting press.
- Building relationships with early stage investors that actively find and fund underrepresented founders who can introduce emerging GPs in their network.
Finding and funding more diverse fund managers and founders is the key to solving this problem because it is the conscious reallocation of capital that makes all the difference. If LPs accomplish this with intention, underrepresented GPs and entrepreneurs are given the fuel they need to create outsized outcomes and generate value for everyone at the table.
Amplifying the work of diverse fund managers during the fundraising process
A common sentiment is that capital raising for fund managers (and founders) is incredibly antiquated and ripe for disruption. This is because fund managers also go through a very network-driven fundraising process with LPs, much like founders do, which turns into a massive bottleneck in the fundraising value chain.
For underrepresented fund managers that come from nontraditional backgrounds, one of the biggest factors that impede their progress is breaking into highly opaque and unnecessarily exclusive Silicon Valley networks. LPs can help break this cycle by introducing high potential underrepresented emerging fund managers to other potential LPs in their network. A key component to this is that there is a growing need for LPs to actively build relationships with emerging fund managers.
Being an advocate and an ally publicly will go a long way in establishing credibility with emerging fund managers to invest in them when the time is right or amplify their work to other LPs in your network. By doing so and helping navigate the due diligence process by serving as a validator of the ability of the GP, LPs can add immense value.
Only invest in fund managers whose values are aligned with that of the LP
One of the best ways to show allyship and contribute meaningfully to solving this problem is to engage in values-aligned investing. LPs control the capital that is the fuel for driving innovation forward at scale and thus, have an undeniable amount of power and influence. If an LP can invest in GPs that align with their values (i.e., investing in underrepresented founders who are building solutions for the world at large) that moves the needle greatly in making the startup ecosystem more efficient and equitable. This ensures that capital doesn’t reinforce bad or unethical behavior or discrimination and stops harmful behaviors at the root.
Push for enhanced reporting standards that keep fund managers accountable
As with any new idea or project undertaken, accountability is just as important as execution. How can LPs keep fund managers and the founders they invest in accountable for making these systematic changes in how we create, invest and build companies? How can we ensure that this movement doesn’t fizzle out and innovation continues to be accessible for everyone to participate in? The answers to all these questions lie in the accountability processes that founders set for their employees, fund managers and VCs set for their founders and ultimately, what LPs set for their GPs. Since LPs are the source of the capital that triggers this ripple effect, accountability standards should be set here and trickle down.
So, what are the right sets of reporting that LPs should be requiring from fund managers? There is a lot of nuance that goes into understanding the key drivers of equity in the tech ecosystem and creating thoughtful metrics to keep GPs accountable.
One of the most popular metrics that LPs track is the number of diverse founders that a fund backs, but this should be taken one step further. Funds should track the year-over-year growth in the number of diverse and underrepresented founders a fund has invested in. Rate of growth is a much more meaningful metric to work toward because it can shine a light on improvements made over an extended period of time — a reflection of a fund’s commitment to making their investing practices more equitable and efficient. Additional metrics that can be used to track the effectiveness of LP dollars being invested in underrepresented founders include repurposing two popular metrics that get tracked by LPs regularly. TVPI is the ratio of the total value of the fund’s holdings (includes both realized and unrealized value) to the capital that has been called whereas DPI is how much money a VC fund has sent back to LPs divided by the amount of money LPs have paid into the fund.
There are three unique components to the above two metrics that are being tracked: the total value of the fund, distributions and paid-in capital. If we can measure the total value of the fund, distributions and paid-in capital in relation to the number of diverse founders in a venture fund’s portfolio, that would help us get a much more granular look at the business impacts of funding more diverse entrepreneurs.
The reality is that any of the strategies outlined above won’t result in the transformational paradigm shift that the tech ecosystem needs — it’s the combination of all of the above with intentional community building that will power this movement forward. Great power comes with great responsibility, and LPs have the power and the responsibility to invest in more diverse fund managers to keep them and their investment teams accountable.