Sovereign power

The Review examines the case for a UK sovereign wealth fund in light of the Covid-19 pandemic
by Phil Thornton


Economic disasters always lead to greater state intervention. From the Great Depression of the 1930s through to the global financial crisis of 2008–2009 and on to today’s Covid-19 pandemic, the UK government has been the lender of last resort.

The outbreak of the pandemic and the lockdowns ordered to contain it have left the government needing to bail out companies with grants and loans to keep them going.

The Plan for jobs report that the Treasury published in July 2020 outlines the breakdown of the £281.5bn of public funding it had provided up to that point in the form of both direct fiscal support and tax deferrals and approved loans. Of that total, almost £73bn had been provided in loans under the various schemes.

In July, the government announced emergency support totalling £30m for one firm, Celsa Steel (UK), to enable the company to continue trading. The Treasury said this would “safeguard a key supplier to the UK construction industry” and secure more than 1,000 jobs, including over 800 positions at its main sites in South Wales. But, rather than taking a stake in the company, the government has issued the money as a loan and expects it to be repaid in full. In fact, all government interventions under the various support schemes are in the form of loans.

TheCityUK, which represents UK-based financial and related professional services, points out in its July 2020 report, Supporting UK economic recovery: recapitalising businesses post Covid-19, that many of these businesses will struggle to repay the debt that has been guaranteed by the government. One of its suggested solutions to tackle the problem is the creation of a new growth capital fund, or the scaling up of an existing fund, to provide businesses with growth capital to help power a business recovery across the country.

Creating wealth

In February 2020, John Penrose, the Conservative MP for Weston-super-Mare, suggests in a report authored for think tank Reform that the creation of a sovereign wealth fund (SWF) would tackle three problems in the UK economy – a history of underinvestment, a failure to convert innovations into commercial companies, and a demographic timebomb.

Writing before the first nationwide lockdown hit the UK, he says that the SWF would, over time, create a huge pot of patient, long-term investment capital for everything from transport infrastructure projects to full-fibre broadband. It would, he suggests, be an ‘anchor investor’ for entrepreneurs and start-up businesses and create a pot of savings to pay for state pensions and benefits.

He says that the fund should be made “the legal owner of all the existing and future state-owned commercial investment funds, for example, those held in the British Business Bank (BBB)”. The fund would invest the cash in investment-grade commercial projects, so it can retain and then reinvest the profits when a loan is repaid.
"When you’re looking at a whole new area of technology there’s greater uncertainty, and the risk ... may be too big for a single company to take on"

Speaking to The Review in a subsequent interview, John says that the impact of Covid-19 has made his recommendations even more timely and relevant because of the expansion of the government’s balance sheet. But he backs the government policy of offering loans to businesses and is cautious about taking equity stakes that could then be rolled into an SWF. “I don’t want public investment to crowd out what would be otherwise perfectly viable privately held businesses.”

However, he says if there are circumstances where those loans have to be converted into equity stakes, they should be held by the BBB, which is operating the government’s range of rescue funds. It can then be absorbed into an SWF. “I want to be studiously silent on whether they should end up taking an equity stake, but if they did do that then the one thing I feel very strongly about is that these equity stakes should end up being run by robustly independent trustees in a sovereign wealth fund,” he says.

Historical lessonsPerhaps there are lessons to be learnt from a government-backed industry bank that was set up in 1945 after the devastation of World War II as part of a political agenda to increase the availability of funding to business.

The Industrial and Commercial Finance Corporation (ICFC) was created in 1945 to provide long-term funding for small and medium-sized enterprises (SMEs) to fill a gap that had been identified among mid-sized companies unable to raise long-term finance. It therefore focused on existing firms, rather than start-ups.

Each investment was assessed on a case-by-case basis and its value was determined by the firm’s past success, according to an analysis by the Civitas think tank published in 2010, The Industrial and Commercial Finance Corporation: lessons from the past for the future. The ICFC aimed to earn respectable profits and act as an accelerator in the process of a firm’s own capital formation by allowing the client to reinvest profits rather than pay them to the bank.
While some investments were loss-making and may have hindered growth, others helped them expand

Diane Coyle, Bennett professor of public policy at the Bennett Institute, University of Cambridge, says the motivation behind the ICFC was to fill a financing gap for SMEs that was identified in the 1930s and which, she says, still continues today. “You could start up a business, but it got to a certain point and there wasn’t finance available and we didn’t have a venture capital sector,” she says. “Although we’ve got more of a venture capital sector now, it’s still mainly about management buyouts, and any tech company that wants to grow has to get venture capital funding from elsewhere.”

Diane, whose latest book Markets, state, and people looks at how societies can best achieve collective decisions about the economy, says there is a good case for public investment in new technologies. “When you’re looking at a whole new area of technology there’s greater uncertainty, and the risk, maybe both the risk taken and the scale of investment needed, may be too big for a single company to take on by itself,” she says.

State interventionThe idea that national intervention can lead to successful business creation will, of course, be countered by concerns that it can distort the way that the market operates and disadvantage existing shareholders.

Perhaps the best-known examples in the UK come from the 1970s, when the state struggled to manage large complex organisations – such as shipbuilders, British Leyland and computer firm ICL – that it had attempted to save from failure.

The official history of the ICFC, 3i: Fifty years investing in industry (1995), written by Richard Coopey, who was then a Fellow at the London School of Economics, and Donald Clarke, an ex-finance director at 3i, notes that a number of ICFC staff were members of the Labour Party that had won power in 1945. They write that, although nothing came of those early links with government, it led to the impression that the ICFC was a quango.

They point to the role of John Kinross, its first managing director, as someone who provided “hard-headed commercialism” to the corporation. However, the ICFC did often participate in the management of some of the companies it held stakes in. While some investments were loss-making and may have hindered growth, others helped them expand. One example they cite is Oxford Instruments, in which the ICFC took a 20% equity stake and injected £90,000 of loan capital in the early 1970s.

The intervention in British Leyland took place in the same era but from a different perspective, when the government set up the Industrial Reorganisation Corporation to restructure swathes of UK manufacturing in 1966. It engineered the merger of the mass car manufacturer British Motor Holdings with the smaller Leyland. Hit by poor industrial relations and frequent walk-outs, by the mid-1970s British Leyland was facing collapse.
"The debt arithmetic is good, the real interest rate is low, and the hope is that doing these kinds of things gets us back to faster growth sooner than we otherwise would"

However, Oxford Instruments was already a success and British Leyland was intrinsically poorly run, so it is hard to tell whether state intervention was the pivotal factor. Early nationalisations in the 1940s such as energy, rail, and coal and steel were political decisions, again making objective assessments difficult. 

An interesting example is Rolls-Royce, which was nationalised by Edward Heath’s Conservative government in 1971 after it hit difficulties as development costs of a new engine over-ran. The company was re-privatised in 1987 and is now one of the UK’s most successful companies, although its existence is in some way due to nationalisation.

More recently, Railtrack was nationalised in 2002 and renamed Network Rail, six years after it was privatised as part of the break-up of British Railways. The private company had failed to secure enough revenue from train operators to make a profit. Public subsidies were withdrawn after a major crash in 2000 in the town of Hatfield, and Railtrack went into administration. However, opinions are divided on whether state ownership has created or hindered value.

John Penrose says that as a Conservative MP, he is hostile to direct interference and insists that his version of an SWF would be set up as a “national insurance trust”, with a heavyweight board of trustees, such as the Bank of England, to maintain its independence.

“It needs to be independent from political interference so it is run on a commercial basis with proper fiduciary responsibilities, and so that it takes sensible investment decisions and is therefore treating taxpayer money wisely,” he says.

Jagjit Chadha, director of the National Institute of Economic and Social Research, says he is concerned that a government-owned SWF would not have the expertise to understand which individual firms to invest in and could end up running a string of losses.

He points to the European Investment Bank (EIB), effectively the EU’s in-house SWF, “which has lent some £120bn [for projects in the UK] since 1973, typically with other lenders doubling or even tripling the value”. He says the EIB would be a good model to learn from. “It’s gone out of its way to understand the requirements of business in the regions,” he says.

While the initial assets of an SWF could come from the stakes the government has taken in companies, now is a propitious time for the Treasury to borrow to top up investments. Historic low levels of interest rates mean the government can borrow at close to 0%. In May 2020, the UK Debt Management Office sold £3.8bn worth of three-year gilts at a yield of -0.003%. This means the government is effectively being paid to borrow.

“The debt arithmetic is good, the real interest rate is low, and the hope is that doing these kinds of things gets us back to faster growth sooner than we otherwise would,” Diane Coyle says.

The pandemic has clearly put the idea of state intervention back on the political agenda. With interest rates at record low levels, using government borrowing to fund an SWF to support businesses that might otherwise fail through no fault of their own could draw wide support. It could be used to support long-term goals, such as tackling climate change, but also to bridge the SME financing gap first identified almost 100 years ago. But there is a clear lesson from history: ensure that the fund is managed at arm’s length from ministers to prevent a repeat of misguided government interference.

The full article was originally published in the February 2021 flipbook edition of The Review.

The full flipbook edition is now available online for all members. 

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Published: 30 Apr 2021
  • Corporate finance
  • Covid-19
  • recapitalisation
  • sovereign wealth fund

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