ROADNIGHT MUSING – JANUARY 2025

MANAGING SEVERE WEATHER EVENTS AND CYCLICALITY IN AGRICULTURAL ENTERPRISES

Australian farmers face a wide range of risks but are particularly exposed to variability in climate and commodity prices. There does not seem to be a year that passes where at least one region of Australia is not in drought, threatened by fire or flood. And price fluctuations are a common feature of well-functioning agricultural product markets. The combination of a major climatic event with adverse price fluctuations can be devasting on farm income and profitability, and the recovery period can take significant investment and time.

Despite these vulnerabilities, the performance statistics for Agricultural farm gate lending are compelling:

1. Droughts have had a muted impact on asset values. While there are pockets exhibiting higher volatility, historical land values have increased year-on-year for the past 20 years. 

2. Productive agricultural land is highly resilient, scarce and has limited correlation to the economic environment. Productivity improvements over time have helped mitigate commodity price cycles.

3. Major bank write off provisions are about 0.15% per annum and non-performing loans are about 2% pa, which is extremely low compared to other asset classes that can be 2-3 times these levels.

Investing in the agricultural sector takes specific skills sets and unique financial analytical skills, making it difficult for all lenders to succeed in this important sector. To successfully invest into the agricultural sector, Roadnight Capital believes financiers need to develop core competencies and a deep understanding across the following areas:

Deep expertise 

It is important to build and maintain a team of financial practitioners with agricultural sector expertise gained from:

1. Growing up or working on a farm;

2. Studying an agricultural related degree;

3. Developed deep industry experience.

A deep understanding of agriculture requires experience, a strong credit assessment process, a clear risk monitoring framework, and expertise to structure and manage loan assets. Agriculture managed well has a track record of producing competitive risk-adjusted returns with relatively low levels of volatility. 

Successful lenders to the agricultural sector have a deep understanding of the seasonality and variability in the sector and have the expertise and patience to manage the risks over time.

Ability to look through-the-cycle

In Agriculture, it is important for lenders to look through-the-cycle, which invariably means taking a medium to long term outlook on the investment. Due to the farming enterprise being a combination of the business and the family home, there is also a deep emotional connection to the property, especially for multi-generational farming enterprises - it can be the family’s heritage with implied moral obligations to future generations. It is not appropriate to immediately force a farmer to sell during times of downturn or severe climatic conditions, often at fire sale or depressed land values. In 2019, the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry recommended that a national scheme of farm debt mediation (FDM) be enacted. The principles of FDM aim to achieve a more consistent and efficient outcome for farmers and lenders going through the FDM process and avoid the pitfalls of enforced land sales at fire sale prices. 

Roadnight Capital takes a minimum 3-year outlook on the agriculture enterprises it invests, and will often review 10–15 years of historical prices/yields/weight for the purpose of:

• Evaluating the reasonableness of base case projection assumptions

• Stress testing against the average of the lowest price/yield/weights recorded over the past 10 -15 years.

• Determining the 75% confidence interval for 3-year projections.

It is also important to review financial farm ratios over designated milestones over the 3-year period. As investments in genetics and land productivity produce better results over time, the lender can structure a tiered farm ratio measurement system. 

Rigorous Due Diligence

Prior to any agricultural investment, the lender must conduct significant due diligence, which will include a physical site visit and specific questions of the farming family. 

Whilst the Federal and State Government have specific drought assistance programs in place from time to time, and Regional Investment Corporation can administer concessional loans on behalf of the Australian Government for farm businesses, lenders cannot rely on these support programs alone. It is also important to review the risk management strategies of the farming family, such as:

1. Reserves - The farmers can still focus on high rotation grazing cell models or high yield cropping enterprises but not push the business model to the point of high vulnerability to climatic conditions. For instance, some of the better farmers will have reserve hay and silage for tougher periods or build farm cash reserves in Farm Management Deposits (FMD’s). 

2. Protect - In the cattle industry, the breeding cycle is longer and herd rebuilding phases can take longer after a major climatic event, compared to other sectors such as cropping. However, some of the best farming models will protect their core breeding herd at all costs through leasing/agistment, moving stock interstate or removing weaners to reduce the stress on the cows.

3. Retain - In recent years, there has been more focus on surface water and soil water retention (through green belts, grading of soil, retention ponds, drainage systems)

4. Plan - Many of the best farming families have a comprehensive fire plan in place, supported by appropriate firefighting equipment, fire breaks and water sprinkler systems. 

5. Forecasts - The canny farmers have a strong sense of seasonal patterns, and the specific strategies required on their farm learnt from years of experience. They often have a keen eye on short and long weather forecasts and adjust their business model accordingly.

Agriculture is considered a conservative investment that offers stable returns over the long term, and the 20-year compound annual growth rate for Australian farmland has been 7.5% p.a. But that does not mean investing in agriculture is without risk. Drought can happen anytime, anywhere in Australia. 

Roadnight Capital developed the Natural Capital Fund in 2021 and has produced strong risk adjusted returns of 10% per annum. If investments are approached with the right expertise, look-through-the-cycle approach and thorough due diligence, Agriculture can provide great diversification benefits for an investor portfolio. At Roadnight, we like the sector thematic of Australia’s growing role in the world’s food supply chain due to its clean, green, and high-quality agricultural products, and proximity to the world’s fastest growing populations in Asia. 

We will continue to source quality agricultural investments for our investors.