Why venture capitalists are missing out on the opportunity to invest in diverse entrepreneurs, how it’s hurting their returns, and what to do about it.

Despite awareness of the opportunity that women and multicultural entrepreneurs represent, venture capitalists aren't making these investments a priority and could be missing out on returns. To better understand why, Morgan Stanley went directly to the source and surveyed a combination of nearly 200 U.S.-based VCs and diverse entrepreneurs who have successfully raised venture capital to identify strategies to help address the funding gap facing women and multicultural entrepreneurs.1

VCs who aren’t actively pursuing investments in women and multicultural founders may be leaving money on the table.

We found that the VC industry has yet to prioritize investing in women and multicultural founded startups, despite acknowledging the opportunity that they could be missing, and when they do encounter a woman or multicultural founder, VCs are rigid in applying their definitions of “fit” and are unlikely to educate themselves about the product, market segment or opportunity before them.

This rigid application of "fit" surprised us, especially considering how inconsistent such behavior is with the reputation of an industry that has aggressively sought opportunities to take calculated “expansion risks” to invest in new and emerging markets—often with minimal precedent or data beyond their own due diligence to back the potential payoffs.

The bottom line: VCs who aren’t actively pursuing investments in women and multicultural founders may be leaving money on the table.

This report makes the business case to VCs—and their Limited Partners—that closing the funding gap is a strategic imperative, and provides them with the playbook they need to go out and take advantage of an emerging market right here in the U.S.


What We Found: The Issue Is Systemic

Despite acknowledging the opportunities that companies founded by women and multicultural entrepreneurs present, a majority (60%) of the VCs we surveyed say that their portfolios hold too few of these companies. An overwhelming majority (83%) say that they can prioritize investments in companies led by women and multicultural entrepreneurs and maximize returns. 

Survey Q: It is possible to have an investment strategy that intentionally invests in women and multicultural entrepreneurs while still maximizing returns. 

However, these sentiments haven’t translated into actions. According to the VCs we surveyed, most VC firms aren’t prioritizing strategies to diversify their portfolios. When asked if incorporating more women and multicultural entrepreneurs is a firmwide priority, 3-in-5 investors say no. Among the white male VCs we surveyed, 13% prioritize investments in multicultural founders and just one third (33%) prioritize investments in companies founded by women. These percentages stand in stark contrast to the women and nonwhite male VCs surveyed, who are almost twice as likely as white male VCs to prioritize investments in diverse founders.

Even among investors who say that they prioritize investing in diverse entrepreneurs, their outdated methods of finding companies may be holding them back. These investors continue to rely on their traditional approach (e.g., connections within their networks, “warm” introductions, etc.) to find diverse entrepreneurs.2 This approach may explain why more than half (53%) of male VCs also believe that there aren't enough women founders out there and 43% say the same about multicultural entrepreneurs.

Survey Q: To what extent do you prioritize finding opportunities, personally or as a firm, with the following types of companies?

The entrepreneurs we surveyed report a lack of diversity within VC firms, despite evidence that diversifying the makeup of investment professionals can help firms improve their exposure to women and multicultural entrepreneurs.

Most VCs are made up of white men. They don’t have the experience or the mindset that things can be done differently. They think they want to invest in women, but until there is more diversity in the senior partner ranks, it won’t change.
– Entrepreneur surveyed by Morgan Stanley

Our survey found that diverse VC firms, when looking at either gender or race, have a higher percentage of diverse founders in their portfolios. Among VCs who have hired more diverse fund managers, LPs, partners or board members, 71% report it as a “very effective” way to increase the diversity of companies and founders they invest in. We also learned that women VCs are much more likely than their male counterparts to have taken specific actions to diversify their portfolios. The multicultural founders we surveyed agreed, with nearly two-thirds of them reporting that they have had more success with diverse VC firms.

Survey Q: Have you or your organization done any of the following things to increase the diversity of the companies that you evaluate, in terms of inclusion of women- and multicultural-founded companies?

Still, diverse VC firms remain the exception, not the rule. Just 11% of the entrepreneurs we surveyed say that they have interacted with VC firms with gender and racial diversity.

Fewer than a third (29%) of VC firms have at least one female partner, according to AllRaise, 2% of investment professionals are black, and 1% are Latino, according to another estimate.3 In other words, the onus is on entrepreneurs to find firms with partners who are more likely to see the potential in their business.

VCs have a reputation for parachuting into unfamiliar territories and doing their due diligence to grasp new opportunities to generate big returns. Indeed, the industry is built on betting on the untested and unproven, seeking out new, emerging and even nonexistent markets. From software and the internet in the 1990s to mobile communications and social media in the early 2000s to cloud computing and autonomous vehicles in the past decade, VCs have consistently made big bets—often with no precedent or data, beyond their own conviction that those investments would succeed.

However, when it comes to investing in companies with diverse founders, they often say that these companies aren’t the right “fit.” Our survey results suggest that VCs are less likely to explore how diverse businesses could be the right fit for their fund, or to consider them as opportunities to take calculated “expansion risks,” compared to other new investment areas. 

There is a claim for market-related issues, but often it's because they are not personally familiar with the market, rather than there being no market available.
– Entrepreneur surveyed by Morgan Stanley

Every VC firm uses its own strategy and investment criteria to determine whether a company is the right fit for their portfolio. “Fit” is an evolving concept that can change as VCs seek out opportunities to invest in new products, sectors, markets or geographies outside of their traditional investment criteria, and VCs have aggressively pursued such opportunities by educating themselves and consulting outside experts to advise them on products or companies beyond their investment criteria. 

Case in point, the VCs we surveyed cited “expansion risk”4 as the top type of risk they are willing to embrace to maximize returns and, on average, 19% of the companies in their portfolios represent an expansion or divergence from their typical investments.

Survey Q: Compared to other types of equity investors, VCs often take informed risks to achieve higher returns. Thinking about your investment strategy, what types of risk are you most likely to take?

Companies and products founded by women and multicultural entrepreneurs that address a market inefficiency or need, which they’ve identified based on their personal experiences, are the exact types of calculated expansion risks that VCs should be considering. An overwhelming majority (88%) of the VCs we surveyed view the lived experiences of underrepresented entrepreneurs as a competitive advantage in identifying problems to be solved and markets to be addressed. Yet our research suggests that VCs aren't likely to educate themselves on the product, market segment or opportunity—particularly when the product or customer isn’t one that the VC is familiar with. 

“Not the right fit for me” and “market-related issues” are among the top reasons that VCs cite for not investing in more diverse founders, suggesting that  their field of vision may be too narrow. VCs who are able to adjust their lens will better see such opportunities.

Morgan Stanley’s Message to VCs: You’re Missing a Trillion-Dollar Opportunity

Despite being famously data-driven, VC firms aren’t acting on the data on diverse entrepreneurs and could be missing out on returns.

Investors’ lack of awareness of women and multicultural entrepreneurs starts at home. Nearly half (45%) of the VCs we surveyed don’t know how the returns from companies with women founders compared to their overall portfolio returns. Most VCs (53%) say they were unsure about the returns from multicultural-founded companies.

Generally speaking, how do the financial returns of the following types of companies in your portfolio compare to the average return for your overall portfolio?

However, some analysis of their own portfolios may show that companies led by diverse entrepreneurs meet or exceed average returns. Consider a 2018 Boston Consulting Group study of 350 startups in the Boston area that contained this startling finding: On average, women raised less than half as much money as their male counterparts, yet they earned 78 cents per dollar invested, compared with 31 cents for the men.  A prominent seed-stage venture firm also found that teams with at least one female founder did 63% better than all-male founder teams, when looking at the change in valuation since the initial investment.

A closer look at the broader marketplace would reveal that companies serving diverse customers represent a huge opportunity to capitalize on consumer segments with plenty of room for more growth. For example:

  • Women drive 83% of all U.S. consumption, through both buying power and influence. 
  • African Americans spend $1.2 trillion annually in the U.S. 
  • Latinx consumers’ buying power is expected to reach $1.7 trillion by 2020.

The larger market trends and demographic shifts will only exacerbate the gap between funding and returns.

Morgan Stanley’s Playbook for VCs

Diverse entrepreneurs hold the key to a trillion-dollar market. Consider the potential magnitude for expansion if VCs invested the same amount of time, capital, and resources in growing these companies as they did in once-opaque areas, such as the internet or emerging markets. To help VCs access returns from diverse entrepreneurs for their LPs, Morgan Stanley has developed the following playbook to seize these opportunities and put their capital to work.

1. Redefine How You Think About "Fit" and Expansion Risk for Your Portfolio

Adjust your definition of "expansion risk" to include companies founded and led by women and multicultural entrepreneurs. This can help expand your networking efforts among diverse entrepreneurs and help you better understand the opportunities they present.

Consider the idea that diverse entrepreneurs are more seasoned players with lower risk. By the time most diverse entrepreneurs get to pitch VCs, they’ve already run the gauntlet and can often demonstrate a stronger proof of concept, management expertise and success metrics when compared with their white, male counterparts.

Women and multicultural entrepreneurs are an emerging market in the U.S. in the same way that the internet was 20 years ago or cloud-computing a decade ago. In addition to chasing new markets and products, consider investing in the new perspectives that diverse entrepreneurs offer and the markets they serve.

2. Diversify

Having more women and multicultural professionals at your fund is one of the most effective strategies for increasing investments in diverse founders.

By looking inward at your hiring and retention practices and prioritizing diversity, you can improve the delivery of results for your LPs. The traditional sources for entry-level VC talent—top business schools—have large enough pools of women and multicultural graduates to fill the need.

In addition to helping VC firms source more diverse entrepreneurs and see market opportunity more clearly, firm diversity also decreases overall risk: The more diverse perspectives VCs have, the more likely they are to recognize opportunities and identify potential pitfalls. 

3. Hold Your Firm Accountable and Be a First Mover—Institutional Investors Can Help

Develop a comprehensive strategy and make it public. Share data about your internal and portfolio diversity. Establishing goals for investing in more women and multicultural entrepreneurs can be an effective strategy for VCs to show their investors their commitment to effecting change; according to our survey, 86% of VCs agree that such goals would benefit themselves and their LPs.

Institutional investors are increasingly focused on the societal implications of what and who VCs are investing in. Yes, returns are important, but the broader ability of VCs to shape key markets hasn’t gone unnoticed. The capital that institutional investors manage ultimately belongs to individuals, who expect them to make smart investment decisions that reflect their needs, perspectives and values. These investors have a responsibility to consider social issues when they invest their assets under management. Working with VCs who invest in more women and multicultural entrepreneurs will help to meet this expectation. 


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