The Intersection of Accounting, Finance and Sustainability: Implications for Private Capital and Private Equity

Environmental, Social, and Governance (ESG) integration within the private equity ecosystem has gradually evolved from a narrowly focused ethical concern into a mainstream investment approach, especially with growing attention from institutional investors. Increasingly, investors, regulators, and stakeholders are demanding that private equity (PE) firms go beyond financial performance to consider the broader impact of their investments on society and the environment. Consequently, this has affected the private equity landscape in relation to how opportunities are evaluated, the structure of transactions and the engagement with portfolio companies. This shift underscores the growing recognition of ESG factors as critical components in determining the financial viability and long-term success of investments.

The screening process of target companies during an investment cycle has traditionally been dominated by financial metrics, such as revenue growth rate, EBITDA multiples and return on investment; this has since evolved to include comprehensive ESG assessment and due diligence aspects. Enhanced due diligence practices now encompass environmental policies, social impacts, and governance structures, ensuring that potential investments align with the investor’s sustainability objectives. As investors increasingly recognise the long-term value and reduced risk associated with ESG-compliant companies, high ESG-performing companies can command premium valuations; in contrast, inadequate practices might lead to discounts or even abandonment of deals.

Moreover, ESG integration for PE firms manifests through incorporating ESG-related covenants in deal agreements. Common ESG-related covenants include requirements for the target company to provide periodic ESG reports guided by sustainability standards, comply with applicable environmental and social regulations, conduct periodic ESG assessments during the term of investment and use funds for green or socially responsible purposes. Such covenants can facilitate smoother exits, especially for deals that have ESG-linked pricing where their sustainability performance is financially material, and for companies with performance-linked targets which would influence valuation adjustments. Incorporating ESG-related covenants in deal agreements ensures alignment between capital use, sustainability goals and responsible investment policies. This shift underscores the growing recognition of ESG factors as critical components in determining the financial viability and long-term success of investments.

Beyond financial viability and in relation to alignment with investor and stakeholder expectations, integrating ESG during a portfolio company holding period fosters trust and enhances the reputation of both the PE firms and their portfolio companies. PE firms do more than provide capital; they act as strategic partners to their portfolio companies, and strategic guidance by PE firms is a key differentiator in enhancing sustainable practices to position companies for a high-value exit. Such strategies include supporting the integration of ESG into a portfolio company’s business model from supply chain to operations and guiding their portfolio companies to comply with ESG-related regulations, including obtaining certifications and ratings, which is not only critical for avoiding fines and penalties but also building a reputable brand. Ultimately, such initiatives could prove invaluable for increasing investor confidence and maximising a portfolio company’s brand value, which aids in negotiating for higher multiples during the exit phase.

Apart from integrating ESG into screening processes, engaging with portfolio companies, and conducting valuations, PE firms can explore other transformative strategies through impact investing. This strategy targets measurable environmental and social impacts alongside financial returns, offering a comprehensive, holistic approach. Unlike traditional responsible investing strategies that focus on negative screening or divestment, impact investing involves actively investing in funds, projects, and enterprises that deliver inclusive outcomes. These investments aim for financial returns accompanied by measurable social and environmental impact, allowing firms to transition from simple strategies like due diligence and exclusion screening to more sophisticated and impactful investment approaches.

Unlike public markets, where ESG integration is more mature, private markets present unique challenges and opportunities for ESG integration. PE firms operating in the East African market face a mix of structural, operational and data-related challenges that limit the full integration of ESG within their portfolio and target companies. Inconsistent ESG standards and limited ESG data availability among non-listed companies, especially when conducting target company screening, leads to comparability issues and incomplete data, thus making it difficult to standardise ESG assessments across different target companies. This lack of comparability and incomplete data can hinder the ability to make informed investment decisions, benchmark performance and potentially expose firms to ESG-related risks.

Despite these challenges, there are strategic opportunities with local regulations evolving with the adoption and localisation of global ESG frameworks tailored for the PE and investment ecosystem. For PE firms, ensuring that their portfolio and target companies align with global ESG frameworks is no longer a peripheral issue; it is becoming a strategic imperative to ensure the companies remain committed to sustainable practices. Significant progress has been made in East Africa to localise global sustainability frameworks and initiatives for companies. Among the most significant are the IFC Performance Standards on Environmental and Social Sustainability, the ESG Data Convergence Initiative (EDCI), and the UN Principles for Responsible Investment (PRI). These standards and frameworks enable companies to measure and communicate the impact of their investments in quantifiable terms, thus positioning themselves for long-term success as they navigate the complexities of balancing financial performance with societal and environmental impact. 

This article was originally published on the inaugural edition of the EAVCA East Africa Private Capital Policy Monitor, which features insights from private capital professionals.

Authors:

Edna Kimenju: Manager, Environment, Social & Governance (ESG)

Ian Mugambi: Consultant, Strategy & Transations Practice

Gabrielle Namadoa: Consultant, Sustainability and Climate Practice 

Asmaa Harunani: Associate, Sustainability and Climate Practice