Alternative investments offer significant opportunities but the risks do need to be managed, writes Peter Worth.
Local authorities traditionally place “surplus” funds in cash-based investments offering perceived low risk income and short term redemption options. But with interest rates stagnating at less than half of one percent, s151 officers are increasingly considering alternative ways to ease budget pressures. Some are investigating potential returns from wind farms, solar panels and travel lodges; others await developments, anxious not to expose taxpayers’ money to unnecessary risk.
Historically, investment vehicle options available to local government were very limited but self -regulation opened up new possibilities in 2003.
Councils can now hold any type of investment approved by members and enjoy wide-ranging powers to trade. The Localism Act 2011 allows participation in any company trading for profit, with no required link back to council functions or the local area.
And if such a link does exist, even setting up a company may not be necessary. A commercial property portfolio within the council boundary can operate quite legitimately without incorporation, relying on economic development powers —although a separate company would limit contractual risk.
Investments that are not confined to traditional cash, or near cash products, can be useful risk diversifiers, removing an element of the portfolio from bank sector risk. For the purpose of simplicity I have classed these as alternative investments. At their best, such investments represent opportunities to make a real difference both to the budget position and the local area through:
- Environmental and infrastructure improvements,
- Venture capital funds supporting local businesses, and
- Increased housing provision — London boroughs of Westminster, Lambeth and Croydon have recently signed off a £45m pooled investment to provide short-term affordable housing accommodation with a projected rate of return of 4% per annum over the next seven years.
Catch
So what’s the catch? Firstly, alternative investments will almost certainly have a different risk profile, and longer lock-in periods. To ensure these risks are thoroughly assessed at the outset, Westminster City Council has developed a “due diligence” procedure using the “6P’s” concept as follows:
- Powers: What legal powers are being relied on?
- Policy: Does the proposal fit within the existing policy framework? Is member approval required?
- Permission: Does the council need permission from the government (or anyone else) before proceeding? Are land and buildings being transferred between the general fund and housing revenue account? Do proposals affect contractual arrangements with third parties?
- Payment: How is the proposal to be funded? Is there a budget or are virements/transfers from reserves required?
- Procurement: Has the proposal been subject to expected procurement and tendering procedures? Do EU requirements apply?
- Press: What spin could the press put on the proposal? Is the council exposing itself to criticism if the proposal, however lucrative, is seen as frivolous, in poor taste, or just not relevant to local people?
Secondly, the role of the Investment Strategy and elected members is key. A good strategy will articulate:
- How alternative investments fit into the medium-term cash flow forecast and the budget framework as a whole.
- An approximate budget for such initiatives given the need to keep cash-based cover for short-term working capital and contingencies.
- Expected approval, monitoring and risk management processes.
- What types of investments the council is keen to pursue – or definitely does not intend to engage in.
Internal audit
Finally, Councils need to recognise that risks will change over time so periodic re-appraisal is necessary. Embedding alternative investments into corporate risk management processes is key, together with adequate ongoing monitoring – at the barest minimum, to obtain and review audited year end accounts.
Internal audit services, having independent oversight of a council’s functions, have much to offer in this regard and could be engaged to review cashflow forecasts and carry out due diligence reviews. They also have an important role to play in supporting the scrutiny process by assessing existing investments:
- Whether they are properly approved and correctly recorded.
- Delivering expected financial and service benefits.
- Represent good value for money at an acceptable level of risk.
Whilst much is made of technical accounting requirements for alternative investments, in reality these boil down to just four issues:
- All investments held for sale are now carried at fair value, so IFRS 13 valuation and disclosure requirements apply.
- All (except directly held property) should be included in financial instrument disclosures.
- Directly held shares and investment property, and some pooled vehicles, are statutorily defined as capital expenditure, therefore included in the council’s capital financing plans, even if purchased from revenue
- If shareholdings confer effective control over other entities, group accounting may apply.
But these are all relatively easy to deal with. The real key to success here is identifying the most appropriate investment opportunities – and managing the governance risk to the council.
Peter Worth is a director at Worth technical Accounting Solution.
