By Martin Newnham and Deo de Jesus, AgCAP

Should investors own and lease their agricultural investments or should they own and operate them? Deciding on what strategy to use depends on investors’ overall risk appetite and the types of risk exposure sought and the relative transaction costs.

To make this decision, investors need to understand why firms organise themselves in the way that they do. In his important paper The Nature of the Firm, Ronald Coase argues that transaction costs explain the extent to which firms organise themselves, i.e. the extent to which firms vertically integrate and sub-contract important functions (Coase, 1937).

Where transaction costs on an open market are prohibitively high, firms will internalise those activities. Transaction costs are more than just the legal and administrative costs of negotiating, they include hidden costs such as loss of flexibility, the cost of enforcement, misalignment of interests and the cost of bureaucracy. Thus, typical activities that are internalised are those where there is asymmetric information which makes bargaining risky (and expensive), asset specificity which means the next best use of an asset is significantly less valuable, where rights are difficult to enforce, or where the activities to be undertaken are uncertain making it costly to create contracts that adequately define the relationship.

In this way, transaction costs can also be viewed as the risks businesses are exposed to when deciding how to organise their business.

At AgCAP, we manage the Sustainable Agriculture Fund, which invests in Australian broadacre cropping and livestock enterprises on behalf of Australian pension funds. This fund predominantly owns and operates its own land but also leases other land off another corporate, which makes us well placed to understand the merits of operating or leasing agricultural assets.

The strengths and weaknesses of the own & lease model and the own & operate model are illustrated in the following two by two:

Generally speaking, because of the flexibility and lower negotiation costs, it is generally less expensive to undertake activities internally rather than externally. However, it is very rare to find organisations that are completely vertically integrated.

One of the reasons why shopping centre owners do not own and operate their shops is because it decreases the flexibility to change the assets’ use should market circumstances change. The loss of flexibility, in addition to the lack of economies of scope, means undertaking these activities is cost prohibitive.

However, the ability to use agricultural land for multiple uses does not mean asset owners should use a lease structure. What is important is relativity, i.e. the degree of flexibility loss in internalising management relative to the transaction and alignment costs associated with a leasing structure.

The range of enterprises that can operate on broadacre agricultural land is limited to a small range of livestock and cropping enterprises and the skills developed by farm staff in farming enterprises can, with appropriate adjustments, be readily transferred to many different operations. This means the degree of flexibility loss when internalising is not as great in agriculture than it is with shopping centres.

This loss of flexibility needs to be weighed against the costs of using a leasing structure. The leasing market in Australia is relatively undeveloped and price discovery of market lease rates is not readily available. This means more resources needs to be spent on ascertaining and negotiating market price in addition to the cost associated with the risk of getting the market lease incorrect. Is it likely to become more developed? That may occur, however, with a backdrop of declining numbers of farms, the supply of lessees will need to come from a smaller and smaller pool.

In addition, the long-term interests of the land-owner is not necessarily aligned with the interests of short-term lessees. As a result, this may mean sensible capital works and other long-term decisions are not made resulting in lost opportunities. We have found that long-term decision-making is certainly affected depending on whether assets are owned or leased.

There are ways to mitigate the advantages and disadvantages of each structure. For example, some investors choose to partner with successful family farms and align their interests while others look to enter into long-term leases with their partners. However, these strategies also have disadvantages that investors need to be aware of and manage, particularly relating to key-man risk and loss of flexibility.

In summary, the right structure for owning agricultural assets depends on individual circumstances of the sector and investors’ views and objectives associated with risk. What is important, is that investors properly consider the implications of these structures and have plans to manage these risks.

Martin Newnham is a member of the speaking faculty at GAI New York in New York, April 25-28, 2016

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