In recent years, several stories have made it into the public domain of institutional investors choosing not to invest in some credit managers because of a lack of diversity at the fund level. Such headlines are apparently the tip of the iceberg as limited partners in the US, in particular, continue to grapple with just how far they are prepared to go in the pursuit of DE&I at private credit funds.
There are certainly signs that DE&I is becoming much more of a factor in fund selection. Jeffrey Griffiths, a partner and co-head of global private credit at Campbell Lutyens, says: “We have seen some managers being rejected by LPs because of a perceived lack of diversity at the fund level. That is limited to the US and to a small number of pension funds in states that are typically more liberal, like California, Illinois or New York.”
Those are big states with a lot of capital to put to work. However, Griffiths adds: “There is an active debate at the political level regarding the legitimacy of DE&I filters, particularly when investing on behalf of public pension pools. Due to concerns around fairness and legality, some states have started to take action to ban the use of ESG and DE&I factors, whereas others have been actively promoting them as part of their official investment objectives.”
Such filtering is arguably easier to deliver on when LPs are launching broad requests for proposals that they expect to attract a lot of submissions, but where they are looking for something narrow and specific they may not find sufficient managers that meet diversity criteria.
“In Europe, investors would like to see more balance but there is no screening taking place. DE&I is addressed as part of broader ESG conversations,” says Griffiths. “There is definitely a desire to see more diversity, and LPs are expressing that, but not with the same intensity seen in parts of the US.”
For the majority of LPs, there is a less hard-line stance and an appreciation that credit funds are working hard to get their houses in order on diversity. Rick Jain, a partner and global head of private credit at Pantheon, says: “For US LPs, I think it is still early days in terms of the importance or weight they place on DE&I in overall manager selection. That being said, more LPs are asking questions from GPs in relation to how they screen, source and underwrite as part of their investment processes, as well as how their teams are constructed.”
Sasha Jensen is the founder and chief executive of executive search firm Jensen Partners and its DiversityMetrics platform, which tracks diversity data for credit funds. She says: “There have been some well-publicised situations where allocations have been reduced because of DE&I, but what we have been seeing is that because so many funds have now hired a head of DE&I or introduced a DE&I strategy, it is very difficult for LPs to turn them away. It is too early on the data side to punish or admonish managers.”
There has also been “a considerable pickup in the quantitative and qualitative requests coming from LPs in the form of due diligence questionnaires and RFP addendums”, says Jensen. “In addition to the questions around commitment to diversity, some are now asking for much more information around turnover in certain departments, promotion rates and so on. LPs are pushing not just to hear what the DE&I plan is, but how that is playing out, what achievements there have been, what goals have been set and how GPs expect to reach those by 2024 and 2025.”
Jensen sees institutional investors only getting tougher in their commitment to DE&I. “There will be much consternation and we will see very different responses from LPs at the end of 2024 if there hasn’t been vast improvement, because plans have been laid out and LPs are really looking to see a shift change in the numbers,” says Jensen.
Another group of LPs is out there actively seeking to back managers that are either minority-led or pursuing a specific DE&I investment thesis. Jain says: “LPs are taking meetings with GPs that are woman-owned, or GPs that have a specific investment focus that is in whole or in part on DE&I, for example minority-owned businesses. It’s hard to tell how much traction these groups are getting in a broader sense, but we are seeing some of these managers getting capitalised or having ongoing success in fundraising.”
Griffiths shares a similar observation: “Most of those investors that do have particular DE&I requirements will often actively seek out managers that meet their criteria and then support them. We definitely see a number of LPs that actively look for minority-owned or female-owned firms, and they are making an effort to support that. The supply of managers populated by professionals from more diverse backgrounds is on the increase, but right now that remains a limited pool of opportunities.”
Across the board, debt funds have had to contend with much more scrutiny of their DE&I practices in recent years, and an escalation in the amount of data being requested.
Nina Kraus, a principal for fund investments at Hamilton Lane, says private credit is a market receiving special attention on diversity. “The DE&I conversation lends itself really well to private credit because at the end of the day it is about managing risk,” she says. “The more perspectives there are in the room, the more you can see around different corners. Having more diverse views on the risk trajectory of your credit positions is a clear net benefit to your investors.”
She says LPs frustrated by a lack of comparable data and benchmarking are having to deep-dive into diversity from a different perspective. “The reality today is that, from a reporting and request standpoint, there is very limited information beyond gender, race and ethnicity, with veteran status and disability occasionally coming up,” says Kraus.
“When we think about diversity, we think about everything from socioeconomic status through to neurodiversity and age, and we don’t prioritise philosophically any one of those over another. Right now, the data is really challenging to track, and everyone is grappling with that.”
Of course, diversity is not the only component in DE&I. “What we like is a focus on the inclusion piece,” says Kraus. “Because if you create an environment where people belong, everybody can participate and have a voice at the table, you naturally attract a more diverse candidate pool and can convert those into full-time hires before developing them through the system.
“Our view is that culture and tone around inclusion and amplifying diverse voices comes from the top, so when we are considering an opportunity in private markets we are asking top of house what their philosophy is, what their policies are, how they see the team evolving and what their net investment has been in maintaining a competitive edge as it relates to talent.”
Some of the metrics being requested include employee makeup at portfolio companies, GP investment process and the use of monitoring tools to identify and manage issues across portfolios, says Jain: “LPs will also seek references with portfolio companies, borrowers or management teams to get a more qualitative sense of approach.”
Kraus says Hamilton Lane is prepared to walk away from an investment opportunity if it cannot get comfortable from a diversity and inclusion perspective. “If there is risk and we are not comfortable that there are enough different perspectives around the table, investing would be a challenge for us,” she explains. “We need to believe a lot to underwrite an investment where there is not a decision-making mechanism that takes in diverse perspectives.”
Private credit was one of the latecomers to the DE&I conversation, lagging nearly every other alternative asset class on most measures for a long time, according to Jensen Partners data. The belief that diversity was a challenge best tackled by control investors took a long time to shift, but in the last few years debt funds have realised they need to embrace DE&I if they are to remain competitive in both the war for talent and the battle for institutional capital.
Kraus, who is part of a global fund investment team active across asset classes at Hamilton Lane, says credit managers are now doing a good job of rising to the challenge laid down by LPs. “We ask GPs to report using the ILPA due diligence questionnaire and diversity metrics template,” she says, “not just during due diligence but also for all existing investments on an annual basis. “Most can keep up with that as long as it is adjusted for the local market, acknowledging certain markets have certain legal requirements on what can be reported and not every talent pool or professional ecosystem looks the same. Overall, I would say the level of reporting is now quite high.”
More work will be needed in the years ahead to demonstrate tangible progress not just on gender diversity but across a much wider range of characteristics, with pressure for more data, transparency and reporting unlikely to dissipate. At the same time, the drive for more harmonisation in data sets and industry collaboration to allow LPs to benchmark managers will be a big theme.
According to Private Debt Investor’s LP Perspectives 2023 Study, just 46 percent of LPs currently rate their GPs’ DE&I efforts at the firm level as good, and only 1 percent rate them as excellent. As more robust diversity data sets emerge over the next few years, it may become even harder for firms failing to take DE&I seriously to impress LPs and attract investor dollars.