Potential dangers of public sector investment in hub sub debt

Overview —

Jim Cuthbert analyses the potential dangers of Scottish Government investment in Hub sub-debt, which may act as a form of ‘concealed’ borrowing from the secondary market.


Jim Cuthbert

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Jim Cuthbert analyses the potential dangers of Scottish Government investment in Hub sub-debt, which may act as a form of ‘concealed’ borrowing from the secondary market.


― Hub is a form of public-private partnership set-up by Scottish Futures Trust which uses private finance to fund the building of public projects now to then be paid back based on future revenue payments (and is therefore off the current Scottish Government’s balance sheet). Over £2 billion of Hub investment is currently ‘live’.

―  90% of Hub capital is raised from senior debt – commonly bank loans. 10% comes from subordinate debt, which is the risk capital of the project and therefore raises a higher rate of return than senior debt (currently 10-11%). 40% of this sub-debt can be invested in by the public-sector or bodies allied to the public sector.

― The likely purpose of investing in the Scottish Government’s own debt is the potential to sell the sub-debt holdings on the secondary market. This offers attractive possibilities for the public-sector, but also potential dangers.

― The attraction of this is that it can act as a ‘concealed’ form of borrowing, as the secondary market investment can create a cash flow that can be used now. Additionally, the capital sum received by the public sector bodies from the secondary market could total somewhere in the region of 2 to 2.7 times the original investment.

― However, there is also potential dangers of this approach. First, a perverse incentive could arise since the greater the difference between the original interest rate on sub debt, and the secondary market rate, the greater the capital return on a secondary market sale. This might mean the public sector may not adequately scrutinise the original rate of interest on sub debt, resulting in it being set too high. Private financiers on the original investment would therefore be making excessive, unearned profits. Second, the ‘concealed’ borrowing rate from the secondary market may be higher than what it would cost the government to borrow from elsewhere. Finally, this form of borrowing could operate outside of the normal prudential scrutiny on government borrowing, raising potential dangers in how the money is used and whether the public interest is being served.

― In order to address this, mechanisms should be established for monitoring. First, the internal rates of return and the phasing of payments on Hub sub debt should be published. Second, there should be mechanisms for evaluating whether sub-debt interest rates are too high. Third, any sales of Hub sub-debt on  the secondary market from any public-sector (or public sector allied) bodies should be made open, including both the capital value realised and the implicit internal rate of return.

― There should also be active arrangements for assessing the results of such monitoring, including the potential for active government intervention to change course if necessary. This requires ministerial responsibility and Scottish Parliamentary oversight, through the Finance Committee. There should also be an active debate now about what sort of performance the public-sector should expect from Hub sub-debt, in order to assess success criteria.

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