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Market-Based Solutions to Vital Economic Issues
Kenan Insight
Jan 12, 2022

A Different Business Case for Diversity

An increasing focus on social justice has shined a harsh spotlight on systemic inequalities in the corporate sector. In response, businesses have renewed their focus on attracting and retaining a diverse workforce. Companies are working to build a business case for diversity along with operating plans to achieve their diversity goals. In this Kenan Insight, we examine the business case for diversity, equity and inclusion (DEI) efforts. We discuss some of the findings from a joint report with EY and use the private equity (PE) industry as a specific case for addressing challenges that face a broad range of companies.

Examining the Business Case for Diversity

There is an increasing body of research examining the relationship between DEI and operating performance of companies. Unfortunately, the evidence around direct operational benefits of diversity are mixed. We begin by reviewing this literature, and then consider a more holistic approach to the business case for DEI policies based on stakeholder expectations.

Several recent studies document a positive relationship between corporate board diversity and firm value for publicly traded companies. Perhaps the most cited work is a series of studies by McKinsey that document better operating performance (i.e., EBIT margins) for a global sample of publicly traded firms with more diverse executive teams. However, recent research by Green and Hand (2020) challenges the relationship between performance and diversity, suggesting there is not a statistically reliable relationship, at least for U.S. companies in the S&P 500. In addition, Green and Hand also point out that the McKinsey studies cannot establish causality because the performance metrics are calculated on data sampled prior to the measurement of diversity.

Among private companies, academic research has found that gender diversity improves venture capital deal and fund performance. Other research documents that sociodemographic diversity among lead partner teams of private funds positively affects buyout deal performance, but that other types of diversity related to professional experience and educational background can negatively affect performance. Furthermore, certain aspects of diversity apparently create challenges and costs that could offset benefits, particularly when implemented without careful consideration of the full range of stakeholders. For example, insincere attempts at creating a more diverse workforce can backfire by creating a toxic culture of tokenism. Other studies show that diverse professionals flee organizations in which they perceive they are tokenized. This evidence suggests that organizations can compound problems if they try to solve diversity challenges by hiring people who are perceived as less experienced — a move that can escalate internal cultural challenges.

Investors may take note of poor DEI policies and may penalize firms by ascribing lower valuations. For example, research examining diversity that is mandated by regulators shows that when boards are forced to diversify by adding less qualified directors, it results in lower firm value. In the PE industry specifically, there is evidence that investors see through attempts by general partners to “window dress” return performance, so it may not be unreasonable to expect the same is true for evaluations of DEI success.

In some ways, building the business case for diversity by focusing only on direct financial performance is a questionable practice. Consider the possibility that diverse teams might result in worse, not better, performance as suggested by some of the research cited here: Would this then be an acceptable reason to not promote a diverse workforce? We think not. 

Stakeholders Driving Diversity Push

As a more holistic alternative, let’s return to the increasingly agreed-on view that there exists a moral case for diversity in the workplace and various stakeholders have a responsibility to act in accordance with those beliefs. The implications of this are more direct and likely to have powerful and positive economic benefits. As various stakeholders demand diversity, companies not adopting effective DEI policies face threats on a variety of fronts, ranging from attracting and retaining talent to regulatory intervention to pressure from outside investors. We consider these specifically in the PE industry because 1) DEI problems are especially severe; 2) the investor base is powerful and increasingly concerned about DEI; 3) talent is always at a premium; and 4) it is an industry we know well.

Consider the following stakeholders:

  • Regulators worldwide are looking more seriously at requiring diversity disclosures and other steps to boost DEI in the industries they oversee. British regulators have authored a working paper outlining their role in DEI, including a pilot data survey. The Securities and Exchange Commission and other U.S. regulators have also been discussing what steps to take, including requiring diversity data disclosures, with SEC Commissioner Allison Herren Lee noting, “We should reflect on how the SEC could more systematically consider gender, racial and other representation disparities in its policymaking.”
  • Employees, particularly among younger generations, prefer to work in diverse environments. Nearly 80% of workers in a 2021 CNBC and SurveyMonkey Workforce Survey say that they want to work for a company that values DEI. And, as noted already, high-quality diverse professionals are likely to flee firms that do not sincerely embrace diversity.
  • Investors (i.e., limited partners, or LPs) are rapidly adopting DEI criteria. More than 180 organizations — including Warburg Pincus, Vista Equity Partners, KKR, Advent International and Apax — have signed on to the Institutional Limited Partners Association’s (ILPA) Diversity in Action initiative since it launched in December 2020. This initiative requires participating organizations to commit to certain actions, including having a DEI statement, tracking hiring and promotions by gender and race or ethnicity, and offering up DEI demographics data while raising funds. A related ILPA survey found that 87% of LPs either have or are developing a DEI policy or statement and 40% are considering incorporating DEI metrics into their diligence processes. In short, PE firms without diverse workforces risk losing allocations from highly coveted institutional investors.

An Operating Plan – By the Numbers

To move toward truly diverse, equitable and inclusive workforces, firms at the most fundamental level have two main levers available to pull: recruitment and retention.

Recruitment. The reality in many industries, and the PE industry especially, is that there are not enough diverse professionals currently in the industry to meet reasonable targets in aggregate. Often, one firm’s diverse hire is another firm’s loss, and so the overall solution must be to attract new diverse workers. Firms must reconsider and rebuild their hiring practices. Many firms already do this by requiring diverse candidates be interviewed for every open position, setting targets and expanding interviewing channels to include, for instance, HBCUs. Firms should broaden the qualifications to include diverse candidates from fields other than investment banking backgrounds, from which the vast majority of candidates currently come. There is some evidence that this is happening already – executives at firms we spoke with said they are increasingly willing to hire at more senior levels from different channels than other PE firms and investment banks, such as consultants and insurance companies.

Retention. Recruiting is low-hanging fruit compared with retention. It’s easier to hire diverse candidates than it is to retain them in cultures that aren’t transforming to become more inclusive. PE has historically struggled to retain diverse talent. For example, one study found that the attrition rate of women in private markets was nearly double that of men. Without solid retention rates, hiring more diverse employees is neither an impactful nor sustainable approach.

A model for diversity integration. To emphasize the essential and complementary roles of recruitment and retention, we have developed a simple numerical model for evaluating diversity goals. While the crux of the challenge lies in building an authentic culture that embraces diversity, it’s useful to understand the mechanics of the problem presented by recruitment and retention. What many may not realize — particularly those who are not fully focused on issues of talent and human capital — is the extent of the commitments that are required for firms to achieve a meaningfully diverse workforce.

To illustrate this, consider an example using a hypothetical PE firm (though this could be any industry) that seeks to increase the percentage of women investment professionals from 20% to 40% as quickly as possible. While this example focuses on women, the same model could be applied to other underrepresented groups.

While the real world is much more complex, assume for the sake of simplicity that all professionals have similar qualifications and the size of the professional staff at the firm is fixed — assumptions that let us isolate the importance of recruitment and retention. Again, for simplicity, assume that new employees are recruited to replace exiting employees, so the key driving variables determining how long it takes the firm to meet its goal are 1) the percentage of new hires who are women and 2) the retention rates of men and women.

We start by considering the case in which retention rates are the same for men and women — specifically, at a firm where 80% of both men and women stay each year. The firm seeks to reach its target of 40% women by increasing the proportion of new hires who are women. Of course, the proportion of women must be higher than 40% for it to ever reach its target and the higher the proportion, the faster it meets its goal. Table 1 shows the number of years it is expected to take to reach the 40% target for different proportions of new hires who are women.

Table 1. Years to Reach Goal with Same Retention Rates for Men and Women

Proportion of new hires who are womenNumber of years to reach goal of 40% women
40% or lessNever

When half of the new hires are women, it takes about six years to reach the goal. Increasing the new hire proportion to 60% leads to much faster achievement and, of course, higher proportions of women new hires (70% and 80%) will result in attaining the 40% goal even more quickly, but the reductions in time are smaller.

This may seem like good news for firms that believe they can recruit women as 60% of their new hires — or it may seem like a big challenge for firms that have been trying to recruit women but are failing to achieve this goal. Either way, it is just part of the story. The assumption that retention rates are the same for men and women is both unrealistic and crucial. Data suggests that retention rates for women in PE are lower than for men, and this is especially true for women in more senior roles and on investment teams.

So now, let’s consider what happens to the expected time to reach the goal of 40% women employees if retention rates are below 80%. Table 2 shows the number of years it would take to reach the goal when retention rates for women are 10, 20 and 30 percentage points lower than for men. The first column repeats the data from Table 1 for comparison. The next column shows that a retention rate for women that is just 10 percentage points lower than for it is for men, which will more than double the time it takes to reach the goal (from 6 years to 13 years) when women make up half of the new hires. Even worse, if retention rates are 20 or 30 percentage points lower for women, the firm will never reach its goal, even when 50% of the new hires are women. Clearly, it is not enough to just hire a slightly higher proportion of women — the firm must retain women at the same rate as men, or it will struggle to succeed.

A more robust approach to achieving the goal of 40% women employees is to increase the new hiring proportion to 60% women or higher. In this case, retention rates are still important, but there is a less dramatic impact from a somewhat lower retention rate for women. Nonetheless, the firm will never reach its goal, even if 60% of new hires are women, when retention rates are much lower for women (i.e., 30 percentage points or lower).

Table 2. Years to Reach Goal with Lower Retention Rate for Women

Number of years to reach goal of 40% women
Proportion of new hires who are womenSame Retention Rate10% Lower20% Lower30% Lower
40% or lessNeverNeverNeverNever

The model shows that firms must succeed on two fronts to achieve and sustain a goal of 40% women employees. They must both increase the proportion of women new hires and aggressively try to retain them at nearly the same rate as men. Again, we note that the same conditions apply to underrepresented minorities and other diverse groups. To help organizations calculate how long it will take them to achieve their diversity targets, we built an interactive tool that uses a few simple inputs to explore different recruitment and retention scenarios. It is available here.

Keys to Success

While the preceding example makes clear the mechanical challenges associated with achieving diversity goals, the challenges to corporate culture and operations are likely to be even greater. There are no easy solutions for generating an inclusive culture, yet businesses will have to commit to real solutions regardless of the cost. The alternative, at least in the case of PE firms, is to face the risk of ruin from losing access to both talent and investors. In our parent report to this Kenan Insight, we outline symptoms of a culture that impedes DEI and address key questions for DEI self-assessment, and invite you to further explore these issues. 

1 See, for example, David Carter, Betty Simkins and Gary Simpson, “Corporate governance, board diversity, and firm value,” Financial Review, 38, 33-53, 2003.

2 Jeremiah Green and John Hand, Diversity matters/delivers/wins revisited in S&P 500® firms, 2021.

3 See, Paul Gompers and Sophie Q. Wang, And the children shall lead: Gender diversity and performance in venture capital, 2017.

4 Benjamin Hammer and Silke Pettkus, “The More the Merrier? Diversity and Private Equity Performance,” British Journal of Management. 2021.

5 Eden B. King, Michelle R. Hebl, Jennifer M. George, Sharon F. Matusik, 2009, Understanding Tokenism: Antecedents and Consequences of a Psychological Climate of Gender Inequity, Journal of Management 36(2), 482-510. Leonard, Jonathan, and David Levine, 2010, The Effect of Diversity on Turnover, A Large Case Study, Industrial and Labor Relations Review 59(4), 547-572. Gündemir, S., Dovidio, J. F., Homan, A. C., & De Dreu, C. K. W. (2017). The Impact of Organizational Diversity Policies on Minority Employees’ Leadership Self-Perceptions and Goals. Journal of Leadership & Organizational Studies, 24(2), 172–188. Milliken, F. J. and L. L. Martins, 1996, Searching for common threads: Understanding the multiple effects of diversity in organizational groups, Academy of Management Review, 21, 402–433.

6 See, Hwang, Sunwoo and Shivdasani, Anil and Simintzi, Elena (2018) Mandating Women on Boards: Evidence from the United States. Kenan Institute of Private Enterprise Research Paper No. 18-34, https://ssrn.com/abstract=3265783.

7 Gregory Brown, Oleg Gredil and Steven Kaplan, “Do Private Equity Funds Manipulate Reported Returns?” Journal of Financial Economics, 132(2), 267-297, 2019.

8 Diversity and inclusion in the financial sector – working together to drive change, BoE and FCA,2021.

9 Allison Herren Lee, “Diversity Matters, Disclosure Works, and the SEC Can Do More,” remarks at the Council of Institutional Investors Fall 2020 Conference, 2020.

10 CNBC and SurveyMonkey Release Latest Workforce Happiness Survey, CNBC, 2021.

11 Diversity in Action: Sharing Our Progress, Institutional Limited Partners Association, 2021.

12 For PE, which is very disproportionately populated by white males, women and underrepresented minorities are typically viewed as diverse employees. In other industries women are better represented, so diverse employee may have a different meaning.

13 Nori Gerardo Lietz, Cloistered in the Pink Ghetto, (2011).

14 Reaping the Rewards of Retention, YSC Consulting and Level 20, 2021.

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