What To Underwrite Equitably? Here's How

Milken Institute and IADEI research distills four practical and evidence-based ways for institutional investors to underwrite more equitably. Let's examine leading practices for each.

What To Underwrite Equitably? Here's How

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Getting to the root cause of why women- and diverse-owned firms control only 1.4% of the more than $82 trillion managed by the US asset management industry requires examining the manager evaluation process to gauge whether the standards used to judge skill and track record are biased. According to leading impact investor and former Chief Investment Officer of the State of Illinois Rodrigo Garcia, minimum GP commitments, minimum fund sizes, minimum track records, minimum check sizes, minimum team experience, and investment styles that may not perfectly fit into portfolio construction and design are all common hurdles with unequal impacts on diverse managers. Let's examine strategies to overcome these hurdles. This article—the fifth article in a series on building diverse and inclusive institutional investment portfolios—draws from a guide for asset owners that Blair Smith and Troy Duffie of Milken Institute and I co-authored with significant input from the Milken Institute's DEI in Asset Management Executive Council, Institutional Allocators for Diversity Equity and Inclusion and its cousin organizations, including Intentional Endowments Network, Diverse Asset Managers' Initiative, National Association of Investment Companies (NAIC), AAAIM, Milken Institute, and IDiF. More specifically, it focuses on the third of four pillars on the path to inclusive capitalism: underwrite equitably. Strategy 12: Forgo Minimum General Partner and Limited Partner Commitments Understandably, consultants and LPs use GP commitments as a proxy for the seriousness of portfolio managers and their alignment with LPs. At the same time, the varying thresholds of GP commitment that are considered 'skin in the game' by different consultants and LPs create confusion. In addition, higher thresholds are a de facto wealth test or barrier for new entrants. Being independently wealthy has become a prerequisite for making the size of GP commitment to a new fund that institutional allocators consider meaningful. Coupled with the wealth gap between Black and White individuals in the US, these higher thresholds limit diversity within investment portfolios.

It is challenging for LPs that must deploy billions of dollars to conduct diligence efficiently on new and small funds at scale. Rather than innovating on how to underwrite and allocate to smaller, newer managers at scale, many LPs rely on their peers' underwriting: Some have concentration limits of 10-20% of a fund's capital, while others require other similar investors to be already invested in a fund. Such requirements can lead to over-concentration in a few asset managers—with the top five asset managers holding 23% of externally managed assets and the top 10 holding 34%. To support emerging managers, if they become comfortable with a fund's team and investment process, LPs may consider serving as the first institutional investor or representing a larger percentage and even the majority of a fund's capital. Strategy 13: Develop Equitable Alternatives to Minimum Track Records

It is generally accepted that LPs prefer emerging managers that have track records. For most LPs, GPs with legal rights to track records are a first filter. However, established asset managers rarely provide portfolio managers with the legal rights to their track records. Some institutional allocators to private equity managers make the effort to call portfolio companies and extrapolate the track records themselves. Unless LPs develop standards that look beyond track records with attribution, high-quality emerging managers may be overlooked. As an example of a more equitable alternative to reviewing minimum track records, Cambridge Associates also follows individual managers through their careers, which potentially can uncover new talent that might otherwise be missed. Strategy 14: Negotiate Equitable Fees

Because smaller asset managers have higher expenses as a percentage of assets under management, they require higher fees to break even. Requiring emerging managers to accept lower fees and lower valuations can starve them of the revenues that they need to attract and retain talent and build successful businesses. LPs may consider forgoing fee breaks from diverse emerging managers. LPs should also ensure alignment of consultant and fund-of-fund incentives with DEI. Side letters in which consultants and funds of funds require fee breaks or no-fee or no-carry co-investments when engaging with diverse and emerging managers can deter some of the strongest emerging managers from continuing to grow and scale their firms.

Strategy 15: Assess Inclusion Holistically

As an asset manager example, Illumen Capital, a California-based venture capital firm that invests in funds of people from disadvantaged backgrounds, requires the GPs it invests in to incorporate anti-bias training into their investment processes. Similarly, Trident, an institutional asset manager that uses proprietary technology and a systematic approach to invest in high-potential small businesses, incorporated leveraging of greater inclusivity of Black American firms, suppliers, and professionals in its commercial-first strategy and pledged that 13% of the value created by its American Dreams Fund would be realized through increased opportunity, conditions, access, wealth, and representation for Black Americans.

Regarding portfolio diversity, the investment team at Trinity Church Wall Street gauges three facets of the diversity of the managers' underlying holdings: (1) the range of ways in which managers promote diversity at investees; (2) the diversity status of portfolio companies, which indicates a manager's ability to source and screen for inclusive investments; and (3) the momentum of manager efforts to promote diversity and inclusion at investees, as well as the diversity and inclusion momentum of the investees themselves.

Calling For Leading Practices

Any best practices and lessons learned on equitable underwriting that you share can inform and accelerate Institutional Allocators for Diversity Equity and Inclusion's efforts to drive DEI within institutional investment teams and portfolios and across the investment management industry.

The last article in this series will discuss two practical and evidence-based strategies for equitable monitoring and engagement and highlight leading practices in implementing them.