Agriculture encompasses a broad swath of economic activities — from providing grower inputs and equipment, to operating farmland, to processing raw commodities and distributing food products. Investment in farmland is a relatively recent phenomenon, and early investors have generally reaped meaningful returns thanks to increasing acceptance. Future return prospects are promising due to supply growth slowing and effective demand growth increasing. The influx of capital into the sector has led to a proliferation of investment products for investors that vary based on their risk and return characteristics, exposures and cost.
Farmland as an asset class is often included as a subset of “commodities.” It is true that farmland produces agricultural commodities, but there are significant differences between farmland ownership and agricultural commodities investment through futures contracts. Farmland derives its value from the discounting of expected long-term cash flows. Annual commodity prices influence cash flows, but a multi-year perspective buffers farmland value volatility. Returns from agricultural commodities, on the other hand, are based on short-term price changes within the contract period and the effect of price differences when “rolling” to next period contracts (known as contango and backwardation). Farmland is a hard asset with vastly lower return volatility and very different return characteristics.
Here is a brief summary of the options available to investors looking for agriculture exposure.
Agriculture-related companies have historically accounted for 1.5 percent to 2.0 percent of the S&P 500, according to Bloomberg. Broadly, they fit into two categories: Those that own farmland, and those that are involved in other parts of the agriculture supply chain. Farmland ownership by REITs is a very small component; farm input suppliers and food processors make up the vast majority of the public markets’ agriculture component. For examples of farmland owners and operators, look to companies like Farmland Partners Inc. and Gladstone Land in the United States, the NYSE-listed Adecoagro in South America, and Costa Group in Australia. For examples of suppliers and processors, look to companies such as John Deere, Monsanto, ADM, Potash, Brasil Foods and Yara International, among others.
Investors looking for liquidity can also purchase commodity futures contracts, agricultural commodity ETFs or actively managed futures-based crop commodity strategies. Buying futures contracts is rare and does not provide long-term exposure to the agriculture industry. Active investment strategies are usually based on global macro views and events or a trading algorithm that is programmed to interpret real-time price signals and make portfolio changes accordingly. In both cases, the source of the returns is driven by short-term views about commodity price movements, the contract roll (contango or backwardation) and the manager’s trading skills.
Commingled funds allow smaller portfolios access to professionally managed agricultural properties or businesses in a familiar structure. A portfolio of commingled funds diversifies exposure across managers and strategies. Fund investors have a wide variety of options available and are able to invest in many crop types and geographies, as well as in different parts of the agricultural supply chain. Some of the downside characteristics of commingled funds include the lack of customization, the relatively high fee drag, and the long lock-up periods. Investment options in commingled funds are increasing in number, and the terms and governance structures for these funds are improving.
A co-investment program allows fund investors to augment their exposure to the asset class or a manager and reduce fees. Occasionally, fund managers wish to acquire an asset that may breach the geographic, property type or size restrictions specified in the commingled fund documentation. In circumstances such as these, fund managers look to outside capital to co-invest in the target transaction so that the fund capital stays within the desired exposure limits. An investor can invest additional capital in a specific deal alongside the commingled fund, typically at a reduced fee. Co-investments require additional underwriting and structuring expertise, and typically an investor has limited time to conduct due diligence. Unless an investor has a large, experienced internal investment staff or can rely on outside resources, such as an experienced consultant to complete the diligence and structure the investment prior to close, it may be difficult to participate. Transaction sizes are generally smaller in agriculture, so co-investments are less common than in other asset classes.
To address some of the limitations of investing in commingled funds, ultra-high-net-worth investors are looking to separate accounts as an attractive alternative. As the sole participant, the investor can unilaterally dictate the terms and investment parameters of the vehicle. The biggest limitation of separate accounts is the scale required to create a diversified portfolio. Building an adequately diversified portfolio of private agricultural holdings requires a minimum of $50 million to $100 million. This large allocation is concentrated in a single manager, so manager selection is critical. A farmland separate account also entails set-up and monitoring costs, which require agriculture-specific expertise and ongoing staff/consultant oversight.
DIRECT ASSET HOLDINGS
Thus far, direct asset holdings have been one of the favored structures of international investors. This approach requires a substantial upfront investment in capable, in-house expertise, sourcing, due diligence, closing and ongoing operational responsibilities. Direct holdings eliminate the fees paid to outside managers and give complete discretion, but at a substantial cost. Unless an investor has been active in the agricultural space for a long time, it can be difficult to enter the market as a newcomer. Farming is an operationally complex business that requires local expertise. Even when third-party operators are contracted to manage day-to-day operations, owner input is critical.
PRIVATE AGRICULTURE INVESTMENT STRATEGIES
The risk and return characteristics of public stocks and futures-based commodity strategies in our view are best suited to equity or hedge-fund type allocations. The following sections focus on the investment strategies employed in private agriculture and the expected risk and return characteristics. We believe the primary factors driving risk and return for private agriculture investment strategies are crop mix, operating strategy and geography.
Annual crops tend to have more stable return patterns, with a larger appreciation component and a smaller, though more consistent, income component. Perennials, on the other hand, have historically demonstrated a more volatile return profile, albeit with a larger income component.
Land owners have different degrees of participation in the actual growing of crops. Some lease land to third-party operators and some operate it themselves, with a whole continuum in between. Broadly, relationships vary by the level of involvement required and the exposure to credit, operational and commodity price risk.
Geography is a key driver of risk and return when it comes to agriculture. When a major producing area has a crop shortfall, other areas benefit from higher global commodity prices. A good example of this is the U.S. drought in 2012: Argentina, another major corn producer region, benefitted from higher corn prices caused by drought in the Midwestern United States. U.S. corn producers with access to irrigation also benefitted. A geographically well-diversified portfolio does not necessarily require foreign investment, simply diversification by growing region.
Though the United States is one of the most developed investment environments for agriculture, there are some compelling reasons to consider non-U.S. investment:
1) Lower production costs, especially labor
2) Falling transportation costs with increasing infrastructure development
3) Higher yields at a lower cost per unit
4) Southern hemisphere produces in the “off-season”
5) Closer to end-user markets for lower total transportation cost
In the United States, investors often have to assemble portfolios of small parcels in typical transaction sizes between $1 million and $10 million. In Australia and Brazil, transaction sizes are typically between $20 million to $200 million, allowing investors to rapidly gain exposure and economies of scale. Intrepid investors in places such as Ukraine have the opportunity to buy at attractive valuations, but have to contend with small transaction sizes and fragmented ownership, in addition to low yields brought about by years of soil depletion and high-intensity farming.
There are a number of options available to investors looking for exposure to agriculture. It is crucial to partner with expert managers and advisers, as there is a very wide dispersion between top-quartile and bottom-quartile operators that can have a dramatic effect on realized returns. Overall, the private equity fund structure can be well-suited to the needs of investors, allowing for a favorable mix of uncorrelated exposures and total return potential.
Steve Gruber is managing director of real assets at Hamilton Lane, and Howard Kaplan is founder and president of Farmvest. Hamilton Lane executives Andrew Bonnarens and Brent Burnett also contributed.