Scottish National Investment Bank: consultation paper

4. The Focus for Investment activities

The mission-based approach

"The missions set for the Bank would provide a focus for its investment strategy, but not constrain the Bank's activity. The Bank should support innovative, high growth Scottish firms in whatever sector they appear other than those activities that may cause reputational issues or go against the principles of the Bank's ethical investment code"

4.1 The Implementation Plan concluded that the Bank should take a mission-based approach to investment. This concept comes from advice from the Scottish Government's Council of Economic Advisers, and specifically the work of Professor Mariana Mazzucato. A mission-oriented approach is consistent with the Scottish Government's National Performance Framework. It focuses on problem-specific societal challenges, which depend on transformative solutions through the interaction of many different sectors. A key feature is that missions are essentially sector-neutral and business neutral, and do not involve specifying the types of business into which the Bank should invest. Mission-based investment should generate both financial returns, as well as grow and strengthen Scotland's economic base by increasing jobs (especially higher value jobs) and supporting new and innovative industries.

4.2 Alongside the mission-orientated approach, the Bank will take on a strategic role investing in a range of businesses, at different stages of their investment life-cycle. In this way the Bank can be both market-shaping and market-creating, opening up opportunities for investment in new technologies and innovation to add social and economic value and allowing it to respond and adapt to changing market conditions.

4.3 Other national promotional banks have a similar approach. Germany's KfW, for example, is mandated to tackle large societal challenges (or megatrends). ^[3]

4.4 The Bank's governance arrangements (see the diagram below) will ensure that it operates a mission-based approach. Ministers will periodically set missions for the Bank to ensure that the Bank's approach to investment aligns with the Scottish Government's economic priorities, with the initial set of missions confirmed ahead of the Bank being fully operational in 2020. Ministers will communicate the missions to the Bank and the Bank's Board will be required to report on how they have responded to the missions set for them, and how the investments made by the Bank are performing.

Bank relationships and structures

4.5 Key to this approach is a Strategic Framework, agreed between Ministers and the Bank, which will be reviewed and revised on a fixed timescale. Along with setting the missions, the Strategic Framework will:

• provide the Bank with its direction and priorities, including the Bank's contribution to the Government's Economic Strategy and the outcomes and areas of Scotland's economic performance on which it will focus through the missions;

• set out the relationship between the Chair, Board and Ministers, and liaison between the Bank and the Scottish Government – including the operation of a Performance and Reporting framework that will include how the Bank is progressing the missions set for it and the setting and revision of a financial target rate of return;

• set out arrangements for the sharing of information by the Bank, such as its Investment Strategy, Risk Strategy and business plan;

• explain how financial provision for the Bank will be made through the budget process; and

• explain how arrangements will work for the Bank to issue shares to Scottish Ministers and return money to Scottish Ministers through dividend payments.

4.6 The Bank's response to the missions will therefore be articulated in its Investment Strategy and business plan which the Board will approve.

4.8 Where appropriate, the new Bank will also integrate existing financing activities provided by Scottish Government and its agencies into its remit and operating model to build on the success of operations and initiatives underway, offering an opportunity to develop strengths and build on existing skills and align complimentary activity by Scottish Enterprise and others.

4.9 The target rate of financial return for the Bank's overall investment portfolio, included in the Performance and Reporting Framework, will need to exceed the Bank's expected rate of return on its investments, and incentivise the Bank's sustained investment performance. A challenging but achievable target rate of financial return is essential to ensure that the Bank becomes financially self-sustaining (in terms of funding its operational costs) in the medium term. An initial rate of return for the Bank will be determined in 2019; it should reflect the Bank's projected operating costs and the forward interest expected from the Bank's pipeline of planned investments (including those to be developed by the Bank's transition team in conjunction with the Scottish Government in 2019).

The Bank's approach to Investment

"It should have the capability to provide capital across all stages of the business growth lifecycle and ensure that, where there are gaps or opportunities, it can address these through a range of financial products"

4.10 While a Strategic Framework for the Bank's activities should be set by Ministers, it is intended that the bank should be operationally and administratively independent in its decision making.

4.11 The Bank's Board will need continually to assess the financial markets, the economy and the needs of business in order to determine what investment products are offered, on what terms, who any investment partners are, how they will be procured, and who the target customers will be. The Bank's approach to investment will need to factor in how to support delivery of Inclusive Growth.

4.12 Plans for investment will be set out in an Investment Strategy, which will be developed and implemented by the Bank's Board. The initial version of the Investment Strategy will be prepared during 2019 and will set the direction for the Bank once it becomes fully operational in 2020. It will take full account of the Strategic Framework and incorporate:

• the Bank's approach to investment, how that will deliver the missions and align the Bank's activities with the strategic direction that has been set for it, and meet the target rate of return that has been set by Ministers;

• how the economic priorities identified for the Bank will be fulfilled;

• the types of product to be offered and the target customers and sectors in which the Bank will invest; and

• the Bank's risk appetite – informing a separate Risk Strategy.

4.13 The Investment Strategy will be periodically revised and updated by the Board, taking account of any adjustments to the target rate of return and missions, as well as market conditions.

4.14 The Board will also be responsible and accountable for ensuring that the Bank maintains an appropriate risk profile across its portfolio of investments and that the Bank delivers against the target rate of return set by Ministers. The impact on portfolio risk will need to be considered by the Board when it agrees its Investment Strategy. The Bank's approach to investment risk and reward (in terms of the investments it makes and the level of return which is generated from these investments), and how it will manage this will be set out in a Risk Strategy which must also be regularly reviewed by the Board.

4.15 The Board's responsibilities and accountability will also include compliance with regulatory requirements (to be set by the Financial Conduct Authority where these apply) and State Aid requirements (set by the European Commission and any successor arrangements being led by the Competition and Markets Authority) as well as for procurement of investment partners within the appropriate regulations and frameworks.

4.16 Ministers will not be involved in determining the Bank's Investment Strategy nor in managing the portfolio risk. They will, however, be consulted on drafts of the Investment Plan and Risk Strategy.

Patient Capital

"Because innovation is highly uncertain and has long lead times, achieving smart, innovation-led growth requires not just any type of finance, but patient finance. The Bank should, therefore, provide access to long-term patient finance where need exists".

4.17 A strong feature of the Bank's approach to investment will be its provision of patient capital in the form of debt (loans) or equity (stakes in businesses, which can include a shareholding). "Patient" is an average term of 10-15 years for a loan or equity investment, reflecting the typical investment lifecycle for businesses as they move from one stage to another (eg from start up to a more mature business seeking to expand activity). Longer terms for investment will be possible, eg 20-25 years, if that's what the Board determines. The longer the overall length of its investments, the less capital that will be coming back into the Bank for re-investment. So in making long term investments the Bank will still need to remain within its profiled and agreed requirement for capital.

4.18 In developing its Investment Strategy, the Bank is expected to have a strong, but not an exclusive, focus on investment in small and medium-sized business enterprises. It should be able to take a different view of risk and reward to other commercial investors, enabling it to offer investment for projects and ideas which would otherwise struggle to attract investment due to gaps in the market and need for new financial products and services. The Bank could still take a commercial view of an investment, but offer a rate of interest which is materially below the private sector commercial rate as long as the underlying products and investments are state aid compliant. In making such investments, which will yield a lower level of financial return than other options, the Board must also be able to show that the target rate of financial return will continue to be satisfied overall and that its risk profile is not adversely affected.

4.19 The Bank's requirement to operate commercially means that it should not consider investing in businesses which are at financial risk, or as part of rescue and restructuring. Financial intervention into businesses of strategic or national importance which would otherwise be at risk of failure will remain an option for the Scottish Government and the enterprise bodies.

4.20 There may be scope for the Bank to develop approaches to lending which may include some guarantees on loans made. However, it is not expected to offer guarantees initially, but will remain an option for government. Any utilisation of guarantees in the future would be as part of the Bank's risk profile, taking into account the need to satisfy the target rate of return and deliver the missions set for it by Ministers.

4.21 The Bank will be able to invest in both UK-registered and non- UK registered businesses and projects, so long as the investments are consistent with delivery of the missions set for the Bank, reflect its approach to investing ethically and sustainably, and facilitate economic growth in Scotland. This ensures that Scotland remains globally-focussed and it is also an established strategy for management and mitigation of risk within investment portfolios. The Board will need to provide stakeholders and others assurance about the risks being introduced as well as those mitigated through non- UK investment, including any ethical considerations.

The Bank's ethical commitment

The Bank should adopt a leadership role with regards to diversity and inclusiveness within its governance, operational arrangement and investment strategy"

4.22 One of the Bank's objects will be that it will invest ethically and sustainably. The way the Bank operates – its culture, governance, and approach to businesses and individuals - must also be different to that of other financial and investment bodies. At the heart of this will be a requirement for the Bank to hold to the following principles:

• Equality

• Transparency

• Diversity; and

• Inclusion

• Established and will be run following the spirit and practise of Open Government

4.23 These principles will underpin all the Bank does and will complement the Bank's duty to comply with Freedom of Information, the Public Sector Equality Duty and the Fairer Scotland Duty. There is also an equalities aspect to be considered in terms of the Bank's investments and who it invests in.

4.24 The expression of these principles and how the Bank will ensure and report on its ethical approach will be set out in an Ethics Statement to be developed, published and reviewed by the Board on a regular basis. There is also scope to consider whether in terms of delivery of missions, the Bank should be specifically prevented from investing in certain sectors or areas as part of its ethical framework, and what these sectors or areas might be

4.25 An initial Equalities Impact Assessment is in development. It will be refined during the course of 2019 as thinking and planning for the Bank's operation and investment frameworks are refined. This work will inform the Bank's first Ethical Statement which should be in place prior to the Bank going formally live in 2020.

Question 3:

Do you agree that the overall direction for the Bank should be set by Ministers through a Strategic Framework, including the setting of missions and performance objectives and a target rate of financial return?

Question 4:

Do you have any views and suggestions on the example of missions, outlined in paragraph 4.7 and what are these?

Question 5:

Do you agree that the Bank should identify and implement an Investment Strategy, which is along the lines suggested?

Question 6:

Are there any arrangements or requirements not already considered that would inform the Equalities Impact Assessment and strengthen and enhance the Bank's ethical approach to investment, and what are these?

Question 7:

Do you agree with the principles approach that is proposed for the Bank, including publication of an Ethics Statement by the Board?