November 25, 2015

Andrew Watters Director Aquila Capital Farms New Zealand

Summary

• NZ Pastoral agricultural investments should be considered as part of an asset allocation targeted at Agriculture. They provide a low cost direct exposure to protein prices with favourable in-market connotations (grass-fed, food produced the way it was meant to be).
• The private equity model, with a high fee structure and a manager focused on generating Alpha returns, has historically been the investment model of choice. ACF NZ itself has bought and managed more than 100 farms on this basis since 1992 – we still operate US$500 million of farms.
• In a well-developed market such as NZ dairy there are alternatives to the higher cost PE model. The core opportunity is to access beta returns generated from NZ pastoral dairying; alpha returns may be impacted by the fact that the NZ market is well informed, there is competition for farm investment and average levels of farmer performance are good. Increasingly, there is the risk that investments made using a PE model and cost structure, will only deliver Beta results.
• At the same time, family farmers who dominate the ownership of farmland in NZ, need access to funding tools in addition to traditional bank debt.
• ACF NZ has developed a dairy farm debt finance product which provides investors with equity-like returns but with superior debt-like security. It is focused on generating beta returns with the minimum of drag from costs, fees and tax. The structure means that investors are not exposed to operational risks yet benefit from regular cash returns related to profitability, and benefit from the potential upside (but not the downside) of changing property prices.
• The result provides investors with a low risk, low cost and scalable exposure to NZ dairy returns, and provides farmers with a much needed funding option to help them secure their first farm, to buy their neighbours property, to manage family ownership issues.

Pastoral agriculture, for the production of milk, meat or fibre, deserves strong consideration for inclusion in any agricultural investment portfolio. Protein demand growth is forecast to be higher than general food demand as consumers with increasing wealth improve the variety and quality of their diets. And pastoral agriculture benefits from low direct operating costs (animals harvest their own feed directly, there is a minimal of depreciating infrastructure) which is really required when global market prices are positive but volatile.

The farming or agricultural investment industry is dominated by variations of the private equity model. Ten year funds with variations of the 2 and twenty fee structure (now normally lower than this) are quite typical. The fund manager or general partner is backed to make quality farm investments, to invest in development to gain a step change in productivity and to outperform average management.

This private equity type model is the basis of our own track record which commenced in 1992. The typical format has been buying farms as underdeveloped dairy farms, or farms to convert to dairy, operating them for a period, then selling once the alpha return had been created. For ACF NZ Ltd (and our related companies), we have done this more than 30 times and we are currently operating more than 50 farms which are at various stages of the journey. We have achieved gross returns of more than 13% p.a. for over 20 years.

But there is at least a proposition that the NZ market, recognised as the “Rolls Royce” of dairy investment opportunities, is a market where the main opportunity is the Beta rather than Alpha returns.

Firstly, it is difficult to generate a development margin by buying and developing NZ pastoral farmland. When buyers consider the purchase price of a property, they tend to establish a ‘developed value’, and then deduct the cost of the development work required. The same applies to converting a farm from sheep or arable use to dairy; the bare land plus development costs tend to be similar to buying an existing farm. Whilst there are some exceptions to this rule, there can be more risk with, for example buying in a more remote or lower quality location.

Secondly, regional growth opportunities are also largely taken up. The Canterbury versus the national market is a case in point. Figure 1 shows that Canterbury farmers have increased milk production from pasture at a quicker rate than the average, thereby creating ‘super returns’ from Canterbury farms. This ‘better than average’ gain has been derived from the conversion from flood irrigation to more efficient and effective centre pivot irrigation.

Figure 1: Milksolids per ha production changes

At ACF NZ we have benefited from the growth available from the South Island market in terms of our own track record. But property prices are now similar on a capital price per kilogram of milksolids, and there are other factors that are starting to bring these regions back to the average.

Thirdly, aiming for Alpha returns does add costs. Farm investment occurs costs on entry and exit, particularly in NZ where there is a foreign investment regime to comply with. And there are not necessarily obvious advantages with increasing scale in terms of operating performance.

At this upcoming conference I will be talking about an innovative dairy finance investment opportunity. We believe it will suit investors looking for a low cost and low risk exposure to NZ dairy, allowing management focus to be devoted to other higher risk higher return parts of the portfolio.

I look forward to hearing your views on this debate.

andrew.watters@aquila-capital.com

Andrew Watters is a member of the speaking faculty for Global AgInvesting Europe 2014 at the Landmark London, 1-3 December. 

The opinions expressed in this editorial are the author's own and do not reflect the view of Global AgInvesting.