Australian farm businesses could do better with different funding models

Adam Tomlinson, Australian Farm Institute

The biggest challenge facing Australian agriculture is the risk of a drought, but it’s not the normal climatic drought that farmers are used to routinely managing, but a drought of capital. The risk arises because Australian farming businesses rely very strongly on debt financing, and there is not the wide variety of different funding models that exist in other sectors, or in the agriculture sectors of other nations.

The potential for Australian farms and agribusinesses to take advantage of the undoubted boom in global food demand driven by Asian middle-class consumers depends heavily on the ability of farm businesses to access adequate capital to enable them to gear up and expand their output. However, loading up farm businesses with extra debt is not always a viable or attractive option, compared to other funding models.

Access to adequate capital was the key focus at the Australian Farm Institute’s recent Funding Agriculture’s Future Conference.

As could be expected, the presentations delivered at the conference sparked a lot of discussion about the funding arrangements for the Australian farm sector. International speakers were also present at the conference and discussed farm and agribusiness funding models in Asia, Brazil, New Zealand and the United States (US).

Interestingly, these speakers highlighted that farmers and agribusinesses in these nations generally have access to funding arrangements that are different and more varied than those commonly utilised in Australia. The key differences include the depth of the funding pool available, the types of investors interested in agriculture, the use of tradeable farm product bonds and equity partnerships to finance farm businesses, the greater utilisation of farmland leasing as a means of entering farming, the role of risk-mitigation insurance schemes, and the role of national farm credit systems.

Assessing the investment attractiveness of Australian agriculture

To ensure that the Australian farm sector attracts the most effective capital in the future it is critically important that investors fully understand the opportunities and challenges associated with the sector. The major advantages associated with investment in the Australian farm sector, from an overseas perspective, include national economic stability, the technological and managerial skill of farm business managers, and the regional trade opportunities for food and fibre exports. Unfortunately however, factors such as climate variability and commodity price volatility frequently deter potential investors. For example, Australian superannuation fund managers and asset consultants generally have a limited understanding of the agricultural industry and as a result prefer to invest in more straightforward assets, such as listed equities.

Interestingly, an analysis of the financial performance of 270 broadacre farm businesses in Western Australia (WA) presented to the conference indicated that these businesses achieved better returns than the gains recorded by the Australian share market All Ordinaries Index during the decade from 2002 to 2011 (Kingwell 2014). The analysis also showed that the average variation in wealth appreciation for these farm businesses was less than the volatility in the All Ordinaries Index over the same period.

Another presentation to the conference identified that Western Australian broadacre farm businesses achieved an annual average return on capital of 4% during the period between 2005 and 2013, but that there were distinct differences between farm businesses. The top 25% of broadacre farms achieved an annual average return on capital of 8% and the bottom 25% achieved an annual average return of 1% (see Figure 1). Analysis also identified that the top 25% of broadacre farms in WA performed well above the bottom 25% during the good years of 2007, 2008, 2011 and 2013, but performed more closely to the bottom 25% in the bad years of 2006, 2009 and 2010.

Figure 1:  Western Australian broadacre farm businesses return on capital* 2005–13.

 

* Inventory adjusted cash-flow return on capital (based on opening land values for each year).
Sources:
    Planfarm, AFI analysis.

The discussion triggered by these presentations aired concerns that funding models for farming in Australia have a long history of reliance on debt funding, display low innovation, are generally too restrictive and not always suitable for corporate structures (Planfarm 2014). To address some of these issues, it was suggested that improvements could be made by offering things like drought clauses in principal and interest finance agreements, a diversity of financial products, off-take agreements, risk mitigation insurance, and models which enable skilled managers to manage bigger areas without necessarily expanding their capital commitments.

Farm business financial indebtedness and debt-servicing

Australian farm businesses are largely funded by debt financing, with funding being relatively cheap and accessible for established businesses over the last 15 years or so. This has generally meant that when farmers have looked to innovate, develop or expand, they have principally looked to the bank to obtain the money by mortgaging their farm land as collateral. It is uncertain however, whether this system can be relied upon so heavily in the future, with productivity growth slowing due to a lack of new investment and a shortage of young people entering farming, due to insufficient upfront equity when trying to access bank funding.

The reliance of debt funding in the Australian farm sector can be illustrated by the trends in inflation-adjusted (real) debt per hectare over the last 24 years (see Figure 2). According to the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) farm survey data for all broadacre industries, the average debt per hectare has followed a similar path to equity per hectare, with both these indicators doubling over this 24 year period in real terms. Unexpectedly however, real gross cash receipts and net-cash income per hectare have not followed the same path. Gross cash receipts per hectare in real terms increased by 40% from the early 1990s to the early 2000s, but have remained relatively static since that time. Real net-cash income per hectare increased rapidly during the late 1990s and early 2000s and has been more volatile on a year-to-year basis when compared to the other indicators.

Figure 2:   Index of Australian broadacre farms debt, equity, gross receipts and net-cash income, 1990–2013.


Sources:       ABARES, AFI analysis. 

In 2011, ABARES reported that farm debt had increased rapidly due to the effects of low interest rates (making debt more attractive), farm size expansion, changes in production from livestock to cropping and the impacts of drought on farm income. Since 2011 however, farm debt per hectare (in real terms) has retreated to the lowest level in seven years, due largely to improvements in net-cash income per hectare for the average broadacre farm business.

Other major factors contributing to the recent decline in farm debt levels include shifts in farmers’ attitudes and bank policies in relation to farm debt levels. There has been a general move by farmers in recent years to reduce debt to a more manageable level following the experience of multiple droughts and commodity price fluctuations during the period between 2002 and 2011. Bank lending policies have also changed since the advent of the global financial crisis (GFC) in 2007. The GFC impacted on bank funding liquidity and credit risk policies at a time when the Australian farm sector was experiencing lower net-cash income due to drought.

Notwithstanding these developments, the real level of farm debt per hectare for the average broadacre farm business in Australia is still twice what it was in the early 1990s.

One way to assess how the farm sector has performed in servicing debt commitments is to look at interest coverage, which is calculated by dividing the net-cash income by the total interest expense. As a general rule of thumb, if the interest coverage ratio stays above 1.5, then the farm business would be considered to have a sufficient financial buffer to service its debts.

An interest coverage analysis was carried out for the average beef, sheep, mixed livestock, and wheat and other crop farm businesses for the period between 1990 and 2013 (see Figure 3). This analysis showed that the average farm business achieved an interest coverage ratio well above 1.5 in most years.

Figure 3:   Interest coverage ratio for beef, sheep, mixed livestock and grain farms, 1990–2013.



Sources:       ABARES, AFI analysis.

Given the relatively sound debt servicing history of the Australian farm sector, an interesting issue for discussion at the conference was how corporate farming models perform financially in Australia.

A motto for corporate farming groups – ‘buy well and manage well’

One of the presenters at the Funding Agriculture’s Future Conference defined corporate agriculture as agricultural businesses where the owner of the capital is separate from the operator (Sackett 2014). The paper noted that the two main advantages of corporate agriculture, particularly for the farm sector, were better access to capital and better access to expertise (specialisation). The presentation also highlighted that the two main performance requirements for corporate agriculture were ‘buying well’ and ‘managing well’.

Some analysis was provided of the track record of corporate agriculture in the Australian farm sector. It showed total annual returns to investors over the period from 2000 to 2013 ranged from -5.4% to an outlier of 20.7%, with the annual average return being approximately 4%. Some of the reasons highlighted for the lack of success of corporate farming in Australia included the lack of transparency in investment proposals, the uncertainty in financial reporting (making comparisons and benchmarking difficult) and the rigid overhead cost structures associated with a corporate model. The competition from successful family owned-operated farm businesses was also noted, as family owned-operated farms generally have a long-term view as well as more management flexibility, accountability and a flat management structure.

Nevertheless, one of the major challenges faced in the Australian farm sector for both corporate and owner-operator farm businesses is competition for investment capital. Table 1 shows that there are enterprise categories of farm businesses that have historically demonstrated similar financial performance to equities and default superannuation fund investment portfolios over the long term, but have generally fallen behind in the last 10 years. This means that for the farm sector to compete with equity investments or to be included in superannuation investment portfolios, the first hurdle to overcome is convincing the investment manager that farm investments will provide relatively competitive returns in the long term – similar to the returns that were recorded in the 1980s, 1990s and early 2000s.

 

Table 1:   Average annual returns for the All Ordinaries Index, default superannuation funds and broadacre farms, 1974–2013.

 Period

 All Ordinaries Index

Superannuation returns*

Wheat and other crops farms** 

Beef farms
(top 25%***) 

Sheep farms
(top 25%***) 

1974–2013

15.2%

10.3%

 

 

 

1984–2013

12.9%

9.7%

 

9.2%

9.5%

1994–2013

11.2%

7.2%

6.0%

8.4%

9.9%

2004–2013

11.6%

6.8%

4.4%

7.1%

8.3%

2009–2013

13.0%

4.1%

2.8%

1.4%

5.3%

2013

14.8%

16.7%

5 %

3.2%

3.2%


* ASFA/APRA superannuation statistics.
** Industry average annual returns including changes in capital value.
*** Industry top 25% based on return on equity and indicates average annual returns including changes in capital value.

Sources:       ASX, AMP Group, ASFA, APRA, Frank Delahunty Pty Ltd, ABARES, MLA, AFI analysis.

Apart from competition within the Australian economy, the Australian farm sector also competes internationally with other agricultural producer-exporter countries for investment capital. When looking closely at the farm funding models operating in major competitor countries, it becomes clear that the Australian farm sector could do better with different funding models.

The following sections discuss the funding models that operate in each of the key competitor countries, with a focus on the models that are potentially applicable to the Australian farm sector.

Brazil’s farm funding models

There are two main farm funding models that are used in Brazil but not in Australia, including the national rural credit system and Commodity Price Reference (CPR) farm product bonds. The rural credit system in Brazil involves both state-owned credit providers and commercial banks. The rural credit system also relies heavily on demand deposit regulations, rural savings allocations, and the Brazilian Economic and Social Development Bank (BNDES) as official sources of funds to the Brazilian farm sector.

The CPR farm product bond allows farmers to access capital by financing what they intend to produce or what they have already stored. Farmers sell a bond specifying a volume of product that they will deliver on a certain date, with no option to default on the delivery commitment. The CPR farm product bond in the hands of the buyer becomes a tradeable product on commodity and financial markets with liquidity in these markets coming from various parties such as farm input suppliers, machinery dealers, commodity trading houses and investment funding organisations.

The CPR farm product bond is a farm funding model that is not readily available in Australia, but which could play a role in future farm funding models. The reasons why a CPR farm product bond market has not developed in Australia may include the smaller scale of farm businesses in Australia (relative to the larger corporate farming sector in Brazil), the lack of risk mitigation insurance available for farm production in Australia, and the lack of agriculture industry knowledge within the financial sector in Australia, in comparison to the financial sector of Brazil.

New Zealand’s farm funding models

The farm sector in New Zealand faces many of the same issues as the farm sector in Australia, including a lack of workers and the high entry-cost barriers facing young people seeking to become farmers. However, when it comes to attracting investment capital, New Zealand’s farm sector is well ahead of Australia’s.

The owner-operator farm business structure remains the dominant structure in New Zealand, and the banking industry remains the dominant source of capital. Farm businesses in New Zealand are mainly involved in dairy farming with over 70% of the national gross value of farm production generated from dairy products. However, as farm consolidation and the expansion of farm size has occurred in most farming industries in New Zealand, there has been upward pressure on the value of farm land. To overcome the challenges associated with the high costs of farm business assets, and to enable young people wanting to become involved in farming, two different farm funding models have been operating successfully in New Zealand. These models are sharemilking and equity partnerships.

The sharemilking model involves two separate farm businesses with one generally owning the dairy cows and the other generally owning the land. It is estimated that 36% of the dairy cows producing milk in New Zealand are owned under sharemilking arrangements. One of the major reasons why this model works successfully in New Zealand and not so successfully in Australia is the reliability of pasture production. To put it simply, New Zealand dairy farm businesses operate relatively low-risk farming systems with pasture and milking sheds, while many Australian dairy farm businesses require additional management for supplementary feed rations and feed storage infrastructure.

Equity partnership models are also more common in New Zealand than Australia. The equity partnership model is similar to a private equity funding arrangement, except that in New Zealand’s case much of the capital being invested into farm partnerships is coming from other farmers. There are numerous iterations of this model but in general a partnership is formed which includes a managing partner involved in day-to-day farm operations and equity partners that contribute capital such as cash, dairy cows and farm land.

The equity partnership models are not widely used in Australia, however, these funding models could play a role in the future. When comparing Australia to New Zealand, a major reason why the equity partnership model has not developed in Australia is likely to be the lack of liquidity in the farm land leasing market. Fortunately for New Zealand farm businesses, farm land does not attract capital gains tax when it is sold, and this means that stakeholders of farm businesses, involved in land ownership, can buy-in and sell-out of equity partnerships relatively easily.

United States farm funding models

The two key differences between farm funding models in the US and Australia are the US national farm credit system and the liquid farm land leasing market that exists in the US.

The US$360 billion in farm debt held by US farmers is split between commercial banks (45%) and the US Government’s farm credit system (55%). Farm debt obligations are generally divided into three types of loans, which are crop/seasonal, machinery, and real estate. The farm land real estate loans are mostly provided by the farm credit system, with interest rate discounts and risk mitigation insurance advantages provided to farmers when lending money to buy farm land real estate. Essentially, these advantages for the farm credit system make it challenging for commercial banks to compete in the farm land real estate lending market, which means that commercial banks focus more on loans that service farm production needs.

In comparison to Australia, the US has a deep and liquid leasing market for farmland (Noonan 2014). This is particularly the case when rising land prices and production costs intensify the financial needs of agriculture, and ultimately creates a greater barrier to entry for young and beginning farmers. Higher prices for land and fixed expenses appear to be shifting the structure of farm enterprises managed by young and beginning farmers from an owner-operator model to a renter-operator model (Kauffman 2013). In 2011, it was estimated that only 36% of farmers younger than 35 were full owners of farm land.

Renter-operator farm funding is not as common in Australia as it is in the US. Some of the reasons why a renter-operator farm funding model is not as prevalent in Australia may include the lack of risk management insurance in Australia, and the taxation arrangements applicable to capital assets in Australia.

The US farm sector is unique in that it has access to a wide variety of revenue insurance products including crop revenue coverage, revenue assurance, income protection, livestock risk protection, and livestock gross margin insurance. These insurance products are subsidised by the government and provide greater security to US investors providing capital to farming businesses.

The US tax system for the transfer of capital assets is also different to Australia with various estate and inheritance taxes impacting on farm land ownership. To avoid hefty taxes, farm land assets in the US are generally transferred to a spouse or charity, or gifted to an individual. These arrangements have generally led to an increasing number of absentee landlords who continuously lease their land rather than start farming it themselves.

Although the Australian tax system includes capital gains tax on the transfer of farm land (except for estates), it has not generally led to the number of absentee landlords that are seen in the US. This is possibly due to farmers in Australia preferring to either roll capital gains into the subsequent purchase of farming assets, conduct intergenerational transfer of the land to individuals willing to become farmers, or simply having more farmers who are content to sell their land and pay the tax.

Conclusion

To ensure that the future of Australian agriculture is adequately funded, it is important that good policy settings are enacted with a long-term vision, an effective market place is created to allow efficient transactions to take place, farm returns and management are improved, and more entrepreneurialism is encouraged.

Australian farm funding has a long history of reliance on debt, with little innovation. The ‘normal’ model is generally too restrictive and not always suitable for corporate structures. As others have suggested, improvements could be made by offering things like drought clauses in principal and interest finance agreements, a greater diversity of financial products, off-take agreements, risk mitigation insurance, and models which allow the separation of farm skills from farm capital.

Additionally, for the Australian farm sector to access adequate capital and to compete with equity investments or to be included in superannuation investment portfolios in the future, the first hurdle to overcome is convincing investment managers that farm investments provide relatively competitive returns in the long term – similar to the returns observed in the 1980s, 1990s and early 2000s.

Undoubtedly, farm funding models operating in major competitor countries are different to the model that is common in Australia, which means that the Australian farm sector may benefit from adopting or adapting some of these arrangements. The models of interest include the farm product bonds utilised in Brazil, the equity partnership arrangements common in New Zealand, and the farm land leasing arrangements in the US which are underpinned by risk mitigation insurance.

References

ABARES (2011), Australian farm survey results 2008–09 to 2010–11, ABARES, Canberra.

Kauffman, N (2013), Financing young and beginning farmers, The Main Street Economist, Federal Reserve Bank of Kansas City, Issue 2.

Kingwell, R (2014), Returns on offer from family farming: some observations, Proceedings of the Funding Agriculture’s Future Conference, Australian Farm Institute, Canberra.

Noonan, G (2014), A perspective from the US, Proceedings of the Funding Agriculture’s Future Conference, Australian Farm Institute, Canberra.

Planfarm (2014), Profitable farming in WA – it’s the small differences, by G McConnell, Proceedings of the Funding Agriculture’s Future Conference, Australian Farm Institute, Canberra.

Sackett, D (2014), A view of corporate agriculture – performance and prospects, Proceedings of the Funding Agriculture’s Future Conference, Australian Farm Institute, Canberra.

Images:  Hipnotic Content, Kyle Taylor 

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