Control Risks: Mitigating ESG risks in Africa

This article is sponsored by Control Risks.

Africa is a continent characterised by numerous ESG risks. Transparency International’s latest index classifies 44 out of 49 countries in sub-Saharan Africa as having a serious corruption problem, for example. But Africa is also a continent that offers unique opportunities to achieve positive social and environmental impacts. 

Indeed, private equity firms have played an important role in recent years in broadening access to services in Africa, such as electricity or mobile broadband – facilities that are taken for granted in developed markets.

Kathryn Fletcher, director at Control Risks, and Shawn Duthie, a senior consultant at the firm, say governance risks pose the greatest concern for investors, and that these can derail efforts to encourage more private sector investment on the continent. However, they argue that by gathering on-the-ground information, rather than relying solely on ESG ratings, private equity investors can often mitigate real and perceived ESG risks, and position themselves to seize Africa’s opportunities. 

Why are private equity firms paying more attention to ESG in Africa?

Kathryn Fletcher: ESG may feel like something that has appeared in the last few years, but it has been around in different forms since the 1960s. Recently, the thinking has evolved away from the ‘do no harm’ approach towards an idea that companies should be creating social and environmental benefits through their investments.

We are seeing more and more legislation that requires companies to provide for greater due diligence and transparency around ESG risks in both their operations and supply chains. There is also civil society, which is becoming increasingly vocal about its expectations for companies to take responsibility for the impacts of their operations. 

Private equity firms are paying more attention to this, in part, because there is significant evidence of the benefits of incorporating material ESG issues into investment analysis and decision-making processes. That is a risk management approach that is going to deliver improved returns. Conversely, the warning signs are there that if a company underperforms on ESG criteria, or if it makes big promises around sustainability but fails to deliver, its reputation will be damaged.

Shawn Duthie: Most of the development finance institutions that are funding private equity firms in Africa are European, and they are influenced by the emerging regulations in the EU. The private equity firms operating in Africa, especially the larger firms, know that if they want to continue receiving funding from the DFIs, they need to follow their requirements on ESG. 

That said, from speaking with private equity clients, it is clear that attitudes are very receptive to ESG. It is seen as a positive thing, not as a hindrance or something that will
lessen returns. 

What are some of the key ESG risks that PE firms face in Africa, compared with when operating in developed markets?

KF: There is often a discussion around which is the most important out of the E, the S or the G. In Africa, I would say that governance should take precedence. If you have the governance in place, and you are managing risks from the top, then a lot of the other elements should fall into place.

SD: When investing in emerging markets, such as Africa, there are a lot more challenges and risks compared with investing in Europe and North America, and it is no different when it comes to ESG. One of the issues is that regulations around environmental protection and labour rights are less stringent in a lot of African countries. Even when regulations are in place, governments do not always have the resources to enforce compliance.

So, for an investor, there is a greater risk that your investment might encounter a social or environmental issue that you would not have in a more developed market. That does not mean a private equity firm should be put off from investing in the continent. The key is to take the necessary steps to ensure you have the clarity that you need prior to making the investment.

Is it more difficult to mitigate ESG risks in Africa?

SD: There are a variety of tools private equity firms can use to ensure that ESG risks to their investments and assets are mitigated. It is important that PE firms take a very proactive approach to mitigating risks. 

We have seen a lot of firms investing in African companies, then realising later that they are facing ESG issues. That has spurred people on to make sure that they are not caught out, and that they instead address ESG right from the beginning. 

The best place for any firm to start is by gathering as much information as possible regarding the ESG risks in the sectors or the jurisdictions in which they are looking to invest. Getting an accurate picture of ESG risks can be more difficult in Africa. It is much more difficult to collect data and intelligence in general in Africa compared with developed markets, and it is no different when it comes to ESG. We are trying to help rectify that with one of our tools to help clients monitor and compare ESG risks across jurisdictions.

ESG data is very valuable when planning investment strategies, but I do not think private equity firms should see acquiring data as being as far as they need to go. It is still incredibly important that they ensure there is full clarity on the ESG risks of their specific investments. That clarity can only be achieved through a clear and co-ordinated investigation into ESG risk factors, which can often be conducted in conjunction with reputational and integrity due diligence. ESG due diligence cannot just be a tick-box exercise – it needs to be bespoke, depending on the nature of the investment and the jurisdiction.

KF: ESG ratings generally provide fairly superficial information about a company. My concern would be that PE firms might spend the money to get an ESG rating and still not actually have the visibility that they need on the specific risks facing their portfolio companies. 

I have my doubts about self-reported information from companies – I’m not suggesting that they intentionally mislead, but they will limit disclosures to answering the questions put in front of them in terms of specific risk areas. If you take a step back and look into the reality on the ground, you are going to get a much deeper understanding.

Is this heightened perception of ESG risk a factor in deterring PE firms from investing in Africa?

KF: I have heard from private equity clients that the barrier is often around governance risks. That is where they feel they are not going to have the transparency they need to really know what is happening on the ground. 

Everyone can see the huge potential for positive impacts on the social and environmental side, which is clearly very attractive to impact investors in particular. Yet when governance risks, especially around bribery and corruption, appear difficult to manage, investors may begin to think that Africa is too risky.

SD: PE investment into Africa is growing, but in general, investors from Europe or North America do not always have a huge amount of knowledge about the continent. As soon as people travel around the continent and see the opportunities, then there is more willingness to engage. 

The risks do not necessarily seem as insurmountable when you are on the ground, compared with if you are in an office in London or New York, for example. Mindsets are slowly changing – ideally, they will begin to change more quickly.

How do you expect practices around ESG in Africa to evolve in the coming years?

SD: The focus on environmental impact investments is now firmly entrenched in the vast majority of private equity firms, and there is a growing recognition that social and governance issues also need to be addressed when looking at investments. Additionally, there is an understanding that addressing these issues does not need to impact the return on the investment and that, on the flip side, addressing them at the beginning can help an investment increase its returns in the future.

KF: It is important to recognise that from the social side and environmental side, people who live on the African continent are at the sharp end of some of those really serious impacts. If you are thinking about issues such as desertification, biodiversity loss or pollution, those are very real and tangible concerns if you live in Africa. It is imperative that companies investing in Africa understand this and do what they can to help bring about changes.

I hope that over time the conversation is gradually going to shift away from ESG being relevant to private equity firms because it leads to financial outperformance, towards an understanding that ESG is necessary because it creates resilient companies.

We need to get to the stage where PE firms move away from a reliance on the more superficial types of ESG data. Investment firms have an important role to play in encouraging companies themselves to move away from a box-ticking approach, and instead arrive at a situation where ESG is a baseline expectation.

We are increasingly going to need to get into the weeds of how companies operate and what the real risks are – transitioning from a focus on financial materiality and into what we call saliency. With saliency, we are really talking about impacts – particularly the most severe negative impacts on people, impacts on environments, impacts on communities. That is the future.