Australian agriculture: Mean fields?

When Chinese fabric producer Shandong Ruyi wanted to make an acquisition in Australia, Lempriere Capital Partners was a logical first port of call. The two companies were already acquainted via the PE investor's parent company, Lempriere, a 150-year-old family-owned agribusiness player that supplies wool to Ruyi. 

Lempriere Capital looked for opportunities all along the textile supply chain, ranging from clothing brands to farms, although few of the latter were of sufficient scale. Eventually they settled on Cubbie Station, a Queensland-based cotton farm with nearly 94,000 hectares of land and around A$320 million ($299 million) in debt.

Cubbie Station wasn't a bad business, but its business model was unable to withstand a prolonged drought. The company went into voluntary administration in 2009 and ironically the rains returned soon afterwards, turning the stressed finances on their head. Ruyi and Lempriere bought the business in early 2013, dividing the equity 80-20.

The transaction bought a hint of controversy - foreign investment in Australian farmland can be a sensitive issue - but it points to a situation that might establish itself as the norm. As Chinese companies became more prolific purchasers of industrial commodities in Australia, they began to consolidate supplies through vertical acquisitions. A similar scenario is envisaged for the broad agriculture space, from beef and dairy to cotton and timberland.

Last December, Australia's fourth-largest abattoir in Kilcoy, Queensland, was sold to a fund backed by Chinese agricultural giant New Hope Group, while China Investment Corporation is said to have been engaged in protracted, and intermittent, negotiations with Tasmania-based dairy operator Van Diemen's Land Company.

Baby steps

These are tentative first steps, though. While Tony McKenna, managing director of Lempriere Capital, has a clear ideas of how the environment will evolve, it is happening gradually. "There is no question that we see a lot of interest from China in Australian farmland but the conversion of that interest to actual transactions is still fairly minimal," he says.

Data points such as the 1,093% year-on-year increase in Australian beef exports to China in 2013 - some industry participants expect shipments this year to be more than double the 2013 figure of 92,279 tons - are readily bandied about in support of agricultural investment theses. It adds impetus to a real assets story seen as increasingly compelling by institutional players globally for reasons that stretch beyond farming.

Yet it remains a relatively new and underrepresented presence in portfolios. With relatively few proven management teams - particularly in Australia and New Zealand - agriculture still needs to prove itself. This means overcoming historical preconceptions and particular concerns about risk-return dynamics.

"If an investor doesn't have a mandate for agriculture I'll never be able to convince him to look at whatever fund we may be raising in that space," says Enrique Cuan, managing partner at placement agent Mercury Capital Advisors. "However, if they do have an allocation it's likely they would want to meet the manager because there just aren't many viable investment options out there."

He estimates there are fewer than 20 high-quality institutional managers in the space.

Preqin doesn't have a specific classification for farmland-focused funds. Taking in the entire gamut of agribusiness from production to distribution, and including managers with a significant but not sole focus on agriculture, only 49 funds globally have reached a final close since 2010, raising $8.9 billion between them. A further 28 are still in the market, seeking $11 billion.

Of the 10 largest funds raised to date, only two, Macquarie Pastoral Fund and TIAA-CREF Global Agriculture, include Australia or New Zealand in their mandates. The Americas tend to feature most prominently.

TIAA-CREF and Hancock Natural Resources Group are generally acknowledged as the largest farmland investors in Australia and New Zealand, although their respective approaches may differ from smaller operators. For example, TIAA-CREF predominantly buys land and leases it back to the incumbent farmers, with any additional capital expenditure wound into the rental fees. Others try to bring their competitive edge to bear by being more operationally active.

"Some investors would rather get a stable return from a lease than the volatility associated with being an owner-operator where you are the landlord and you have soft commodity and seasonal exposure," says John McKillop, managing director at AgCap, formerly known as Australian Farms Fund Management. "It is a consistent return of 4-5% versus wild swings from losses through to 15%-plus."

These swings translate into a model under which 80% of the profit comes in three out of 10 years, with 50% of the return generated by capital gains on the land when exiting. It requires discipline in pinpointing which projects and management teams to back, when to enter and at what price, but also a long-term commitment. A typical seven-year PE holding period might not be enough to ride out the volatility.

McKillop cites Stanbroke Pastoral Company, a 500,000-head cattle enterprise where he spent two years in the early 2000s, as the extreme example. AMP's life insurance unit sold the asset in 2003 for approximately A$490 million - a substantial undervaluation given the reported cash returns when it was sold on less than two years later - but the investment still generated an IRR of 24%. AMP's holding period was 39 years.

As manager of the Sustainable Agriculture Fund (SAF), which was set up to aggregate cropping, livestock and dairy assets in Australia, AgCap places itself in the owner-operator category, typically partnering with management teams. So does Milltrust International Group, a farmland investor in Asia, Latin America and Africa that targets a net IRR in excess of 15% on combined capital appreciation and production income.

An acquired taste

Assessments of LPs' appetite for these assets should begin with the broader contextual question regarding their approach to inflation hedging. Over the past 30 years investors have enjoyed relatively low levels of inflation, allowing portfolios dominated by public debt and equity instruments to deliver returns that exceed inflation rates. There is increasing awareness that, should macroeconomic conditions change, performance will be driven by exposure to assets that preserve value in an inflationary environment, notably real assets.

"When we talk to clients, the story we get was in the 1990s we had a 5% allocation to real assets and today it's 15% and by 2025 it will be 25% of these institutional portfolios. There is a huge search for the assets that fit the bill in terms of what they are trying to do," David Brand, CEO of New Forests, told the AVCJ Australia & New Zealand Forum in Sydney earlier this year.

Agriculture and timberland - New Forests' specialty - are two of numerous real assets classes that offer an inflation hedge. The question is whether LPs are comfortable with the volatility that comes with agriculture.

A few showed their faces in February when the Adveq Real Assets Harvested Resources Fund acquired 18,000 hectares of Australian almond orchards from Olam International for A$211 million. LPs that participated as co-investors included Municipal Employees' Retirement System of Michigan and Danica Pension from Denmark. Although this is a lease-back deal, Tim McGavin, CEO of Laguna Bay Pastoral Company, which sourced the deal and now manages the local holding structure, describes these groups as classic real assets investors.

Laguna Bay Pastoral's target market comprises pension funds and endowments. "Our perfect investor would be a defined benefit pension fund that is unlikely to have redemptions or need huge cash flow and dividends, so we can re-invest," McGavin adds. "It is long term, patient capital. And at the moment it comes from North America."

Simon Hopkins, CEO of Milltrust, adds European institutions to this list. The firm recently closed an investment in an Australian cotton project, having identified a business that was grappling with the succession planning issues faced by so many family-owned farming groups where the founder is approaching retirement. A European pension fund made a sizeable seed commitment to the deal. Another European pension fund put money into a Milltrust dairy venture in New Zealand.

Not so super

One constituency rarely mentioned is the Australian superannuation funds, despite the fact that many of them arguably should be in the market for long-dated assets to match their long-dated liabilities. The SAF is backed by seven foundation investors, five of them superannuation funds. In response to an interview request on opportunities in agriculture, one of these groups played down its involvement in the fund, saying the commitment was small and others would be better placed to comment.

There are several reasons for this wariness. First, superannuation funds have struggled with the risk-return dynamics. Members are entitled to move their pension savings between providers and fund performance is marked to market every year to facilitate comparison. The volatile short-term returns tied to agriculture could undermine a portfolio and result in members cashing out and taking their savings elsewhere.

Second, there have been numerous high-profile failures in agriculture investment in Australia. Managed investment schemes (MIS) are the classic example.

The schemes were set up in the 1990s as a retail structure that allowed individuals to invest in timber plantations and agribusinesses and receive an immediate tax deduction on the sum committed. Interest mounted in the years running up to the global financial crisis and a host of MIS providers emerged. They borrowed substantially to finance the acquisition of land assets used to create their products and when the crisis hit many providers went bankrupt.

The difficulties encountered by the likes of PrimeAg, a cropping and cotton investor that was taken private last November after consistently trading below the value of its net tangible assets, have contributed to a loss of confidence in listed agriculture vehicles.

A key issue is that so much of the investment return comes from the capital gain on the land and this can't feature in annual financial reports. It leaves analysts targeting a price-to-earnings ratio of 10-11x EBITDA while returns might be only 4-5% until an asset is exited. "These vehicles aren't right for land-rich agricultural investments because the capital gain is so critical to overall performance and you can't bring it into the profit and loss accounts," says AgCap's McKillop.

Third, the headlines created by farmers who borrow money to fund expansion but then find themselves on the wrong side of a drought or land price correction and unable to service their debts has resulted in a perception problem.

It is debatable to what extent these headlines reflect the reality - mass bankruptcies or quiet debt rollovers by accommodating banks - but the seeds of negative sentiment may already be there. McGavin of Laguna Bay Pastoral notes that it is not unusual for the superannuation fund employees tasked with assessing the space - if indeed there is anyone at all - to have a previous acquaintance with it, perhaps through family farming connections.

"Most of the pension fund managers are cynical. There are guys whose fathers or uncles were farmers but couldn't make a good living out of it because they were sub-scale. They didn't see what I have seen, which is large-scale, profitable corporate farming," McGavin explains. "There is a lot of misperception because people have been tainted buy a model that was broken."

There is a long-term expectation that Australia's pension funds will follow their US and European counterparts and include agriculture in real assets allocations. The vision of the future shared by several industry participants is of farmland operating in a similar fashion to real estate with aggregated assets held in publicly traded investment trusts or in the hands of private funds and large institutions.

However, the only person willing to put a date on this estimated that agriculture is where real estate was 25 years ago. Even on a global level, the industry trails real estate enormously in terms of advisory talent. An institutional investor looking to buy an office building has the luxury of countless consultants at its disposal plus in-house expertise. Not so agriculture.

"The pension fund professionals who run the real estate programs have typically been investing in the asset class for many years and have relevant experience. Many are often hired from one of the big real estate firms," says Mercury's Cuan. "Unfortunately the number of people in this industry who transition to a pension fund is almost zero."

Customized solutions?

The manager pool must therefore also deepen, with GPs proving their credibility to a skeptical domestic LP base by executing on investment theses. An interesting characteristic of a nascent asset class is that, particularly with larger institutions, the structures through which they participate are not yet a function of habit - there is room for experimentation and customization.

Milltrust, for example, operates the Emerging Markets Land Opportunities Fund, which offers investors exposure to a diversified portfolio of assets, but each project is structured as an individual special purpose vehicle with shares issued according to the size of individual investments. This means institutions also have the option of picking and choosing their exposure. Each deal is highly scalable, with a target of $250 million per project, so there is scope for flexibility in timing - a group could come in at the seed stage or once an asset is running and requires capital for expansion.

AgCap is likely to follow a similar hybrid model of direct and fund exposure for its next investment structure. The firm is looking at a roll-up deal in Australia's dairy space, leveraging relatively high milk prices but depressed land prices due to debt burdens. Initial discussions with potential Chinese investors indicated a preference for direct exposure.

"The average herd size is 220 cows so there is capacity to do a roll up and list it," says AgCap's McKillop. "The hardest thing is finding the right management. You can't just go into the street and advertise for a dairy manager; it is very specialized and you need the right structures in place."

In using operational expertise to bridge the gap between Chinese groups and Australian natural resources, it is possible that private equity investors might also devise a means of addressing the volatility issue in agriculture.

What is required is a partner to underwrite part of the risk by agreeing to buy a certain portion of future output. Lempriere's McKenna claims to have held discussions with one large corporate that was keen to follow the model. Lempriere would then be able to package up the investment in the farm as something that "looks more like an infrastructure investment" in that the guaranteed returns could effectively be divided up to produce a more consistent returns profile.

This would be easier for the superannuation funds to handle, although there is some skepticism as to whether it can work in practice.

Queensland government-controlled investment manager QIC has been engaged in broadly the same discussions with Chinese companies. The idea is that these agreements would be the precursor to lasting relationships and equity partnerships on new projects - taking the trickle of deals exemplified by Ruyi and Cubbie Station to a steady flow.

"The first step could be guaranteed supply through an off-take agreement that allows farmers to plan production better," says James Ieong, senior advisor at QIC. "By creating these relationships, the farmers are able to prove they can operate efficiently and then perhaps work together with their Chinese customers on future projects."

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• Topics
• Australasia
• Industrials
• Agriculture
• Australia
• Macquarie Funds Group
• AMP Capital Investors
• CIC
• Adveq Management AG