Editor's note: This is the third in our series examining diversity in venture capital. Read the first story here, our second one here and sign up for our newsletter to get the latest updates.

For all the well-intentioned talk on social media and beyond about the need for diversity and inclusion after the killing of George Floyd, there is one thing that speaks louder than anything else in venture capital: Money.

There is certainly a considerable amount that VCs and founders can do to improve diversity, but those in the industry say it is the limited partners who fund the whole ecosystem who could make the biggest difference.

"It's the LPs that have the power and can demand who they should or shouldn't be investing with," said Sue Toigo, co-founder of the Robert Toigo Foundation and chair of Fitzgibbon Toigo & Co.

At this moment of heightened public awareness, forcing big public pension funds to commit to putting more of their dollars in funds controlled by minorities could have a major impact. These public institutions, unlike their corporate kin, represent a wide and diverse swath of the country, making investment decisions for public servants like teachers, firefighters and municipal workers.

Two major funds, CALPERS and the Illinois Municipal Retirement Fund, illustrate the stark differences in the rules that govern pensions and the people who manage them.

"Our sources of capital are the LPs – like the city of L.A., CalPERS, foundations, and endowments," said Kate Mitchell, who co-chaired the National Venture Capital Association's first diversity and inclusion committee in 2014 and co-founder of Scale Venture Partners. "Their constituents are diverse, and they care greatly about this."

Just 2% of VC investment partners identify as African American or Latino and less than 10% of VC-funded companies are led by women or people of color, according to PledgeLA. LPs could greatly increase both numbers, according to Paul A. Gompers, a professor at Harvard Business School who studies the demographics of finance.

"Who you invest in looks a lot like who you are," Gompers said. "We know there are underserved pockets of entrepreneurs out there and those opportunities could perhaps create greater returns."

In response to the #MeToo movement, the Institutional Limited Partners Association, the industry voice for pension funds, foundations and sovereign wealth funds, expanded its due diligence questionnaire in 2018 to measure ethnic and gender diversity as well as hiring and promotion. Those changes, Mitchell said, have had a noticeable impact raising the bar with firms that must now answer to questions about hiring and diversity.

"It isn't done in a day," she said. "If you are going to make it happen, you have to make it a sustained effort."

Two Approaches: California and Illinois

CalPERS headquarters in Sacramento.

The granddaddy of pension funds, California Public Employees' Retirement System, divested from apartheid South Africa in 1986 and got out of tobacco stocks in 2000. It also doesn't invest in thermal coal miners, manufacturers that make guns banned in California and businesses operating in Sudan and Iran. But prioritizing diverse funds has proven trickier because of the 1996 voter-backed Proposition 209, which CalPERS says bars it from giving preferential based on race, ethnicity or gender.

"LPs love to use Proposition 209 as the reason why they can't do anything," said Emanuel Pleitez, co-founder of East Los Capital who runs an annual conference aimed at educating officials that sit on institutional boards about how to invest in asset classes. "But you can still gather data and be transparent and be sure that the public knows what you are doing. There's a massive opening for LPs to do their jobs that's about picking the best managers and vendors that are diverse."

Pleitez argues that by not emphasizing diversity, public institutions have tipped the scale of wealth toward a class of white asset managers who have gained outsized profits.

In an effort to legally promote diversity, CalPERS, which manages about $400 billion in assets, started an "emerging manager" program in 1991. But last year it slashed the already small program from $3.5 billion to just $500 million in assets under management.

CalPERS declined to make anyone available for an interview. A spokeswoman explained the reduction occurred amid a broader effort to reduce fees and increase returns by shifting to managing 95% of private equity investments internally, up from 80% before. (CALPERS says during the last fiscal year it also "engaged" 700 companies to encourage greater diversity on their boards, half of which did so.)

An internal memo obtained by the website CIO warned that terminating the program "could receive media or legislative attention" but said the cuts were necessary because of long-term underperformance.

"A lot of the women and minority funds have actually closed," said Toigo. "All of the data indicates when you have diverse boards and diverse leadership you have better returns. I would argue you're actually violating your fiduciary responsibility by not paying attention to the data. Unless you're only selling to white people, if I was at a firm I would want every point of view represented in the investment process," said Toigo.

The Illinois Municipal Retirement Fund (IMRF), with $44.8 billion in assets under management, has taken the opposite approach of CalPERS', placing a high emphasis on diversity in its investment decisions.

"It's not about whether you can just do diversity or meet returns," said Dhvani Shah, IMRF's Chief Investment Officer. "We can do both."

As of the end of last year, minorities managed 33.8% of IMRF's actively managed assets, a 19.6% increase from 2018.

Shah says she is mandated to prioritize diversity under the Illinois Pension Code, which states that pension funds should "increase the racial, ethnic, and gender diversity of its fiduciaries, to the greatest extent feasible within the bounds of financial and fiduciary prudence."

IMRF's annual return for 2019 was 19.57%, beating the industry benchmark of 18.68%.

"I think Illinois can serve as a model," said Shah.

Rachel Uranga contributed reporting to this story.

Editor's note: This is the third in our series examining diversity in venture capital. Read the first story here, our second one here and sign up for our newsletter to get the latest updates.