November 27, 2016

Agribusiness is a young asset class. Back in 2002, when Pampa Capital started fund raising to invest in this sector, Ag Investing was on nobody’s radar. Today it is a relevant class given the surge in commodity prices, its negative correlation to inflation and growing concerns about food production and water usage in the context of current demographic and environmental trends. Food security has become a true worry of many sovereign governments and it will challenge and reshape the future of grain origination. Over the next decade, we will see governments and businesses around the world moving closer to the farm gate.

Misconceptions and inefficiencies abound in this sector, which has been historically subsidized in many regions of the world. The pressure on water and natural resources to meet our food production needs in the next 30 years is mind-boggling. Nevertheless, current inefficiencies are equally large. Here are some examples. First, water waste by irrigation systems and practices outside the U.S. is above 90 percent; primarily because of flood irrigation. Second, 40 percent of fields are over-fertilized. Third, on average only 7 percent of the glyphosate sprayed actually impacts the plant. This is also true when applied in different proportions, as the chemicals sprayed on crops don’t reach the disease because the applications are general and not targeted. Fortunately, conscience of these issues has been building and new innovations are flourishing as entrepreneurs realize the size of the problem and the opportunity. This trend is evident with agtech venture investments increasing more than six-fold to $3.5 billion dollars in 2015.

In the meantime, incumbent business Ag models upstream are being transformed as input, crop protection, equipment and service companies battle to gain control of the farmer´s decision-making process. Seeds and chemicals are critical yield drivers in both GMO free and GMO row crop farming practices. The companies supplying these inputs have and will attempt to bundle products and services to sell the farmer the most expensive and largest package of seed, fertilizer, and crop protection chemicals, along with weather predictions and other services. Thus, we see the current wave of M&A among the top agricultural seed and chemical multinationals.

On the other hand, machinery and equipment companies are assembling platforms with a combination of a full equipment line (tractors, seeders, sprayers, combines, and silos) and services to offer a more precise application of inputs to the farmer. New high tech agricultural equipment will allow farmers, among others, to make more efficient decisions in terms of seeding densities and fertilizer use. For example, many companies do mapping of soil types. However, the technology that will likely prevail will be the one that will enable planters and sprayers to apply variable densities according to the soil mapping footprints. Variable seeding density is an important change that will sweep across the industry. AACREA (www.aacrea.com.ar), a highly respected independent Argentine non-for-profit organization, has shown that densities of 35,000 plants of corn per hectare on non premium or uneven farmland have had yields of 9,000 kilograms versus 12,000 kilograms with densities of 80,000 seeds. The lower density cropping is primarily a protection to drought, as there are fewer seeds competing for water. This is a change from focusing on output to focusing on return on investment.

Furthermore, precision farming equipment will enable the farmer to seed dissimilar soil types with diverse seeds characteristics, such as maturity dates or different traits, at different depths and densities, all at the same time. Machines will also be able to fertilize according to each plant and spray chemicals, insecticides and herbicides, according to specific needs. These will be the machines that will likely shape the future of precision farming. An example of this is the new technology in sprayers that can identify chlorophyll and only spray weeds, reducing chemicals application by 70 percent. These are machines and farming practices that not only save huge amounts on money because of lower use of inputs, but also are more environmentally friendly given the lower chemical usage. A recent industry report by Goldman Sachs estimated that precision spraying by itself has a $15 billion addressable market with $50 billion potential value-add.

As information technology continues to penetrate agriculture, new ag companies will also emerge, offering niche products and/or farm management software platforms that will compete with incumbents to enable farmers to make the correct decisions to have the highest crop yields, while lowering input costs. For example, data-based farming management systems that provide information to choose the seed that has the correct biotech traits, determine the most efficient application with the least amount of fertilizers and/or the more favorable use of chemicals and/or equipment. All the information on climate history and quality of land is readily available and public. The companies that will likely prevail in this space are those that will have proprietary algorithms and software platforms that consolidate and process individual farm data, predict weather and other crop patterns, while selling the smarter solution to the farmer.

This is clearly a very exciting time for Ag investing. Technology will advance at a faster speed and the constant incorporation of innovation will likely continue to revolutionize the supply side of this equation and its business models. Farmers and farm contractors will be required to be more sophisticated and look for “smart” and “precise” tools that will enable them to maximize output and price and reduce costs. The supply chain will likely tighten, flushing out unnecessary intermediaries. Even outside the farm gate, new technological developments in information technology, genetics, biology, robotics and illumination will generate alternative ways of “manufacturing” food, the so-called “vertical farms.”

Nonetheless, the advent of these new technologies will not necessarily result in successful business models and investments and it’s too early to tell who the winners will be. The implementation of these new technologies may likely face human resources, social, cultural and environmental constraints that may delay or even halt their development. The key to make successful investments in Ag is thus directly correlated to the manager’s ability to understand the impact of these new technologies, their limitations and timing, as well as the farmer’s mindset, its cultural barriers and their decision-making process. A bottoms-up approach to understanding the human resources, cultural and managerial constraints is essential to ensure that the proposed technologies are embraced by the farmer. Farming is not only about economies of scale, but also economies of detail.

Farmland and Ag businesses up and downstream are primarily owned and operated by families who are third or fourth generation. Changing the corporate culture of a family business and developing the human resources are by far the most critical factors. Management has to be proven in order to succeed. Once professional management is in place the race begins, in no specific order, to make the correct capital expenditures, implement the correct MIS, look for standardization of processes, implement medium term strategies, understand the role of engineering and or R&D and incorporate the best international technologies and practices, disintermediate suppliers, find different sales channels, etc. These factors will drive growth and also gross margins and EBITDA. Implementing these strategies successfully can translate into an important increase of cash flows and asset values, which at the end are the main drivers of shareholder value and investment returns.

The new challenge that must be addressed has to do with “Ag sustainability.” According to the World Resource Institute, a 69 percent increase is required in food calories to feed 9.6 billion people by 2050. Today Ag contributes 24 percent of global greenhouse emissions, 37 percent of landmass / soil usage and 70 percent of water withdrawal. These variables are critical in order to understanding the magnitude of the arduous tasks that we are faced with over the next decades.

Purchasing agricultural assets, such as farmland, avoids incurring many of the business execution risks and is perceived as a secure way to preserve capital and hedge against inflation. However, investing with the best managers one can expect above inflation cash-on-cash returns in the single digits, with higher returns heavily dependent on land appreciation drivers and future legislation. As successful early investors in farmland, we know it is key for investors to take into account not only location (land and water quality plus proximity to ports), like any real estate investment; but also geographic diversification; management constraints when reaching certain land scale determined by human resources bottlenecks; and legal and nationalistic concerns that may limit liquidity for larger blocks of land in emerging markets. Also, climate changes and its impact on water availability is a growing concern when purchasing farmland for the long-term. To increase returns in farmland production, investors should look to either provide solutions that improve farming productivity from the input side (machinery, seeds, information technology, etc) or directly add value to the commodities produced to avoid transporting only water. Transporting raw corn, for example, is basically transporting water. The freight costs are enormous and infrastructure is lacking in non-subsidized and taxed farming economies. Efficient agriculture is thus about finding the most efficient ways for raw crops to be produced and integrated to yield proteins or some high-end premium specialty foods. There will always be a market for high-end premium specialty foods that be tagged with price premiums. Examples are, French Brie and Roquefort cheeses, Italian Parmigiano, Arborio rice, spices such as saffron, Spanish Jabugo ham and Italian prosciutto, non-farmed fish, non-mineralized drinking water, grain finished aged beef, to name a few. These products will always have an important premium that the consumer is willing to pay and compensate for higher production costs. This niche is very interesting and attractive in terms of margins but has a very complex set of managerial challenges that are difficult to roll up and consolidate.

In conclusion, Ag technology, precision or “smart” farming, inside and outside the farm gate is a reality and will play an increasingly important role in farm productivity over the next decades. But the basics of agriculture will not change. The farmer will use the information technology and precision machinery, only if it is simple to use and allows him to make significantly smarter decision in terms of use of natural resources, inputs, production factors and disease alert. Ag investing is and will continue being an important and attractive investment theme. The production of sustainable and healthier food supply is and will be an important investment area for institutional investors. Investors will need to be informed to decide where to invest in assets or businesses in the value chain based on their risk-return profile and investment horizon. On the other side, firms that can understand the dynamics of food production inside and outside the farm gate, as well as the farmer mindset, will be the ones to capture these industry trends and offer the highest returns for investors.

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By Alejandro Quentin, Founder & CEO of Pampa Capital – a Latin America-based private equity firm specialized in Agribusiness with operating offices in Buenos Aires and Sao Paulo.

Alejandro Quentin is a member of the speaking faculty at Global AgInvesting Europe in London, December 5-7, 2016.

The opinions expressed in this editorial are the authors’ own and do not reflect the views of GAI News.