Agriculture – Ripe for Institutional Investment

Agriculture offers a range of investment options capable of fulfilling numerous portfolio objectives. In meeting one of society’s most fundamental needs, investments in “Ag“ can come in many forms. The sector’s diversity and resiliency have been on full display during various economic downturns, including those arising from the efforts to respond to Covid-19. In this way, Ag is not unlike infrastructure and real estate. The inexorable demand for food stands in stark contrast to other sectors, which have suffered since governments have put in place policies to stanch the pandemic’s deleterious effects.

Although we find the rationale compelling for investing in Agriculture, several historical barriers have made it difficult for institutional investors to deploy capital at scale. In the last 15 years, however, the sector has made several inroads to becoming a realistic investment option for large, sophisticated investors. There are more managers that can provide access to the space and more vehicles for doing so: Secondaries and co-investments are becoming common. What has been a highly fragmented sector is seeing greater consolidation. The combined effect of these factors, in our opinion, translates into an attractive opportunity for investors and a natural extension of LPs’ existing real-asset portfolios. In other words, Agriculture is ripe for institutional investment.

Introduction To Agriculture

As seen in Figure 1, we use the term Agriculture to describe four categories of investments:

» Farmland: Leased and operated farmland and associated biological assets and equipment used primarily to produce crops and animal products.
» Agri-Infrastructure: Leased and operated irrigation, intensive production, storage, and logistics assets.
» Agribusiness: Businesses involved in the provision of goods and services that support the Agriculture supply chain (e.g., farming inputs, agronomy services, marketing and processing agricultural commodities).
» Agri-Technology: Businesses that develop the technological solutions to enhance productivity, quality, and environmental outcomes across the entire supply chain.

Because each of these categories embodies varying degrees of real-asset and operational intensity, investors can use Ag to meet an array of risk and return objectives.

FIGURE 1 | AGRICULTURE VALUE CHAIN

Source: StepStone Group.

Why Should Investors Consider AG?

While each category offers different portfolio attributes, the sector as a whole revolves around a supply chain fulfilling the essential need to provide food, beverage, feed, and other industrial feedstocks for society. Unlike many other goods that we can live without, the need for sustenance is absolute. This resilient demand over the short, medium and long run provides the basis for Agriculture’s investment traits (Figure 2).

FIGURE 2 | AGRICULTURE VALUE PROPOSITION

For illustrative purposes only.

ATTRACTIVE LONG-TERM INDUSTRY FUNDAMENTALS

Agriculture involves the production of grains and oilseeds, dairy, meat, fruit, nuts, vegetables, and fiber that are consumed by humans and animals or used in industrial applications. Demand growth for these goods is a function of population growth, rising incomes, and dietary trends. Supply growth, on the other hand, depends on the availability of land and water, growing conditions, and the application of technology to keep pace with demand growth.

Structural Demand Growth

» Population growth—The world’s population is expected to reach 9.7 billion by 2050.⁴ While overall population is expected to grow approximately 0.9% per year, the middle class, which constitutes 42% of the global population, is expected to grow to 63% by as early as 2030 (Figure 3). The associated increase in incomes is expected to drive demand for calories 0.2% above the rate of population growth, resulting in the need for 30% more calories by 2030 compared with 2017.

FIGURE 3 | POPULATION AND CALORIE GROWTH

Source: UN Food and Agriculture Organization, 2019; Brookings Institution, 2017; StepStone analysis.

» Income effect—Rising incomes result in greater consumption of all food groups including high-calorie foods like meat and dairy. As illustrated in Figure 4, the shift in preferences also has a multiplier effect on the demand for agricultural products: The production of animal products requires material amounts of grains and oilseeds. GDP growth also supports greater demand for feedstocks for industrial uses such as biofuel and fiber production.

FIGURE 4 | INCOME EFFECT ON FOOD DEMAND

Source: UN Food and Agriculture Organization, 2019; Brookings Institution, 2017; StepStone analysis.

Constrained Supply

» Arable land and water—The availability of farmland and water is diminishing owing to urbanization and population growth. Arable land per capita is expected to continue to shrink at a rate of 0.7% per year between 2015 and 2030 (Figure 5).

FIGURE 5 | ARABLE LAND (HECTARES PER PERSON)

Source: UN Food and Agriculture Organization, 2019.

» Production yields—The growth rate of production yields for key grain crops has decelerated during the past 30 years. While still positive, productivity growth has stabilized around half of what it was between the 1960s and 1980s (Figure 6).

FIGURE 6 | AVERAGE ANNUAL GROWTH RATES FOR MAJOR CROP YIELDS

Source: UN Food and Agriculture Organization, 2012 & 2018; StepStone analysis.

LOW CORRELATION WITH TRADITIONAL ASSET CLASSES

Ag’s profits depend on production—a function of growing conditions and productivity innovations—and demand, which is mostly a function of inelastic food consumption. Because demand is generally stable throughout the economic cycle, returns from farmland, a proxy for Ag, show a relatively low correlation to other asset classes such as bonds and equities, as illustrated in Figure 7. Consequently, Agriculture has the potential to increase portfolio diversification and reduce overall portfolio volatility.

FIGURE 7 | CORRELATION OF AGRICULTURE RETURNS (1991-2019)

Source: Bloomberg, December 31, 2019.
Note: US Bonds = Barclays US Aggregate Bond Index; Global VC = Burgiss Venture Capital; US Equities = Russell 3000 Index; Global PE = Global Primary Buyouts; US Real Estate = NCREIF Real Estate Index; Global Infrastructure = Burgiss Infrastructure Growth.

CAPITAL PRESERVATION

Because of Ag’s vital importance, and the longevity of most farmland assets, Agriculture investment returns display strong resilience to fluctuations in economic and financial market cycles. Figure 8 shows farmland investments have generated a positive return in each of the last 29 years. They have also demonstrated their ability to better preserve investor capital through economic cycles relative to other sectors. This is most evident in the wake of the GFC, when equities and real estate experienced considerable volatility and periods of negative returns.

FIGURE 8 | CAPITAL PRESERVATION THROUGH MARKET CYCLES

Source: Bloomberg, December 31, 2019.
Note: Farmland = NCREIF Farmland Index; Real Estate = NCREIF Real Estate Index; Equities = Russell 3000 Index.

INFLATION HEDGE

Agriculture primarily produces consumer staples—a key component of consumer price indices. This linkage between farmland returns and inflation bears out in US Department of Agriculture data, which imply a correlation coefficient of 0.57. As illustrated by Figure 9, farmland returns have tended to increase during periods of elevated inflation—particularly during the 1970s. Consequently, Agriculture investments are considered a natural inflationary hedge for portfolios.

FIGURE 9 | INFLATION PROTECTION (1960-2019)

Source: USDA, StepStone analysis.
Note: Income return = Return to operators + Interest; Growth Return = growth in land value per acre.

ATTRACTIVE RISK-ADJUSTED RETURNS

While investors are often concerned with return volatility arising from Ag-specific risks, analysis of historical data suggests the risk level (as measured by standard deviation) is no worse when compared with other asset classes. This is supported by analysis of historical Sharpe ratios, which shows that US farmland, a proxy for Agriculture, offered the greatest reward for risk ranked alongside other sectors, as illustrated by Figure 10.⁵ Although Agriculture-specific risks may include commodity price cycles and production seasonality, a well-constructed Ag portfolio balances these risks with stable demand over long periods and limited volatility correlated with other parts of an investment portfolio.

FIGURE 10 | SHARPE RATIOS (1991-2019)

Source: Bloomberg, December 31, 2019.
Note: US Farmland = NCREIF Farmland Index; Global PE = Global Primary Buyouts; US Timberland = NCREIF Timberland Index; US Real Estate = NCREIF Real Estate Index; US Bonds = Barclays US Aggregate Bond Index; US Equities = Russell 3000 Index; Global VC = Burgiss VC.

Expected Risk And Returns For Agriculture Investments

The primary institutional Agriculture investment strategies are farmland and agribusiness, which are the focus of this analysis. There are, however, opportunities to invest in the other two categories, and infrastructure may form part of a farmland investment.

AGRICULTURE RETURNS

Agriculture returns vary in absolute terms as well as in the relative contribution from income generation and capital appreciation based on the category of investment. Even between farmland types, returns can vary materially owing to a combination of factors. Annual crop returns, as represented by the NCREIF Farmland index, have the lowest return profile, having generated total returns of 8.7% with 45% attributable to income and 55% to capital appreciation (Figure 11). Agribusiness has delivered the highest returns of 16.9%, of which only 16% is attributable to income with 84% driven by capital appreciation. This reflects the private equity-like strategy typically pursued by managers active in the agribusiness sector, as well as the benefit of leverage.

NCREIF Farmland returns, however, are unlevered, and managers typically apply less than 30% of leverage. The underlying variability in annual income is best illustrated by Figure 12. Annual crops have shown a more stable income profile compared with permanent crops. This is because in effect 100% of revenues are derived from rent, given the leased nature of the annual crop index. This stands in stark contrast to the permanent crop subindex where leases account for just 18% of properties by value. The remaining 82% is owner operated with revenues generated from harvest sales, which are subject to varying degrees of operational, commodity-price, and production risks. The income premium for permanent crops reflects both the higher proportion of operated properties versus leased properties, as well as the higher income profile of permanent crops given the material proportion of value tied up in finite-life biological assets that typically do not appreciate over the life of the asset and must be replaced at the end of their useful lives.

As shown in Figure 13, annual crops have demonstrated a higher level of variability in capital growth than in income. Although key annual crop prices have experienced a sustained trough since mid-2013, capital appreciation has grown at a positive, albeit slower, rate. This speaks to the resilience of farmland and highlights its defensive nature, reflecting the illiquidity that comes from sentimental attachment to the property, the synergistic value from assembling closely located farmland holdings, and the long-term investment horizons of farmland owners who tend to sell only as a last resort given how hard it can be to replace valuable parcels of land.

Capital growth for permanent crops has been more variable compared with annual crops. Although both types of crops are subject to the commodity-price cycle, differences between their life cycles translate to differences in production yields, profits, and farmland values. Unlike annual crops, which are harvested every year, permanent crop yields increase as plantings mature, then taper off as they reach the end of their useful lives, similar to aging infrastructure. A cycle of reinvesment, income generation, and capital appreciation ensues.

Constrained Supply

Agriculture returns vary in absolute terms as well as in the relative contribution from income generation and capital appreciation based on the category of investment. Even between farmland types, returns can vary materially owing to a combination of factors. Annual crop returns, as represented by the NCREIF Farmland index, have the lowest return profile, having generated total returns of 8.7% with 45% attributable to income and 55% to capital appreciation (Figure 11). Agribusiness has delivered the highest returns of 16.9%, of which only 16% is attributable to income with 84% driven by capital appreciation. This reflects the private equity-like strategy typically pursued by managers active in the agribusiness sector, as well as the benefit of leverage.

NCREIF Farmland returns, however, are unlevered, and managers typically apply less than 30% of leverage. The underlying variability in annual income is best illustrated by Figure 12. Annual crops have shown a more stable income profile compared with permanent crops. This is because in effect 100% of revenues are derived from rent, given the leased nature of the annual crop index. This stands in stark contrast to the permanent crop subindex where leases account for just 18% of properties by value. The remaining 82% is owner operated with revenues generated from harvest sales, which are subject to varying degrees of operational, commodity-price, and production risks.

FIGURE 11 | RETURN CONTRIBUTION BY SUB-SECTOR

Source: Bloomberg and StepStone Private Markets Intelligence, as of December 31, 2019.
Note: Annual and Permanent Crops = NCREIF Farmland Index; Agribusiness = StepStone Agribusiness Index of GP realized investments.

FIGURE 12 | INCOME RETURNS

Source: NCREIF Farmland Index.

FIGURE 13 | CAPITAL GROWTH RETURNS

Source: NCREIF Farmland Index.

The income premium for permanent crops reflects both the higher proportion of operated properties versus leased properties, as well as the higher income profile of permanent crops given the material proportion of value tied up in finite-life biological assets that typically do not appreciate over the life of the asset and must be replaced at the end of their useful lives.

KEY RISK AND RETURN DRIVERS

Agriculture’s returns are fundamentally a function of the cash flows generated from agricultural assets and the required rate of return (read: the capitalization rate) for different segments of the sector. Still, whether using the discounted cash flow methodology or the income valuation methodology, we believe three fundamental factors drive sector-level profitability (and returns): commodity prices, production volumes, and productivity.

» The long-term growth rate of commodity prices is important to long-term revenue and profit growth. But because commodity prices tend to follow cycles and do not grow in a straight line, they are often the greatest driver of short-term returns.
» Production volume trends, owing to farmed area and production yield growth, directly translate to farming revenues and underpin agribusiness activity through the entire supply chain.
» Enterprise-level productivity growth, measured using total factor productivity (TFP), incorporates the efficiency to increase outputs relative to inputs through operational practices and technology adoption, reflecting the cost of production and productivity gains.

Commodity Prices

A key component of agricultural profitability is the prevailing market prices for individual crops or products. As shown in Figure 14, food and soft-commodity prices have grown over the long run. Between 1969 and 2019, the FAO Food Price Index, which tracks a basket of international commodities, grew at 2.9% per year; corn and almond prices grew by 2.1% and 4.0% respectively over the same period. Figure 14 also highlights periods of significant volatility and price depreciation. Changes in production, mostly due to weather conditions, and the resultant market supply tend to account for most of this price volatility. By contrast, consumption growth tends to be more stable and inelastic; however, individual products can face material changes in demand due to consumer trends, government demand subsidies, and trade barriers.

FIGURE 14 | FAO FOOD PRICE INDEX & SELECT COMMODITY PRICES

Source: USDA National Agriculture Statistics Service, UN Food and Agriculture Organization, NCREIF Farmland Index 2019.

In assessing the practical implications for underwriting, it is essential to view the relevant commodity price cycle over the short, medium, and long run, as well as the outlook for key end markets. The combination of historical price regression and futures curves may offer an objective methodology for estimating a long-term forward price curve; however, many products do not have sophisticated financial markets and lack the data necessary for this approach. When historical pricing or futures curve data are scant, investors might look at the price of imports, the cost of substitute products, or the marginal cost of production; they might also build demand and supply models to assess the short-, medium-, and long-term outlook for prices. These options, however, become increasingly complicated and require extensive industry networks, especially when evaluating prices on a global scale.

Production Trends

Production trends are a function of both farmed area and production yields. Whereas farmed area is usually fixed, especially in developed markets, there is often scope to shift between farming activities for any particular farmland. This is an ever-present trend in Agriculture, where farmers are continually seeking to put farmland to its highest and best use, whether that be converting from pastoral livestock to annual cropping, or from annual cropping to permanent cropping. These trends, which tend to be slow moving, must be understood to grasp the production outlook for any given product.

The other factor upon which volume depends is productivity yield growth. Seasonal volatility notwithstanding, production yields for corn, the largest annual crop by farmed area and value in the US, have grown at 1.1% per year since 1961, as shown in Figure 16. Almonds, the largest permanent crop in the US by area, have seen production yields grow at a CAGR of 1.7% over the same time period. Better genetics, disease treatments, technological innovation, and farming practices have all contributed to this long-term increase in yields.

FIGURE 16 | CORN & ALMOND YIELDS

Source: USDA National Agricultural Statistics Service; UN Food and Agriculture Organization.

The combination of evolving farming practices and productivity growth is a key reason corn, almonds, and agricultural volumes as a whole have increased over the years. Diversifying your portfolio across different products and production regions is a common strategy for mitigating production volatility risk. In addition to showing how corn and almond yields have grown over time, Figure 16 also illustrates the point that unfavorable conditions for one product can be offset when conditions for another product are more favorable. For example, between 2009 and 2012, corn yields fell by 25%, whereas almond yields increased by 25%.

Productivity Growth

The ability to produce more only represents a single factor of productivity and may not be enough to ensure steady profit growth. In all likelihood, profit growth requires efficient use of inputs such as fertilizer, chemicals and sprays, fuel, labor, and capital. Between 1954 and 2017, US agricultural output grew at a CAGR of 1.61% while inputs grew at 0.06%. This implies the TFP grew at a CAGR of 1.55% as shown in Figure 17. In other words, Agriculture has shown it can produce more using essentially the same level of inputs, which reinforces sustained growth in cash flow generation across the Agriculture sector. That the broader US economy’s TFP grew at a rate of 0.69% only serves to underscore one of Ag’s key competitive advantages: the potential to generate competitive returns over the long run.

FIGURE 17 | US TFP GROWTH

Source: USDA, January 2020.

In summary, the key factors of commodity price growth, production trends, and TFP collectively drive revenue and margin growth—all of which underpin long-term returns for Agriculture investments. Commodity price cycles are the primary driver of short-term return volatility. While it is difficult to forecast prices, investors should be mindful of how prices compare with their long-term sustainable levels given the implication for returns in the short to medium run. Periods of price deflation typically precede periods of low returns, and vice versa.

1 World Bank. 2020. Employment in agriculture.
2 National Cattlemen’s Beef Association. 2019. “US Cattle Production Sustainability Overview.” Vehicle estimate based on estimated average passenger vehicle emissions of 4.6 tons per year by the United States Environmental Protection Agency.
3 Goff, Lauren. 2018. “Precision Agriculture’s Impact on Nutrient Management in Agronomic Crops.
4 UN Department of Economic and Social Affairs. 2019. “World Population Prospects.”
5 Sharpe ratios measure an asset’s return per unit of volatility.
6 Preqin, December 31, 2019. Includes unrealized value and dry powder. Preqin data are continuously updated; historical values subject to change.

This document is for information purposes only and has been compiled with publicly available information. StepStone makes no guarantees of the accuracy of the information provided. This information is for the use of StepStone’s clients and contacts only. This report is only provided for informational purposes. This report may include information that is based, in part or in full, on assumptions, models and/or other analysis (not all of which may be described herein). StepStone makes no representation or warranty as to the reasonableness of such assumptions, models or analysis or the conclusions drawn. Any opinions expressed herein are current opinions as of the date hereof and are subject to change at any time. StepStone is not intending to provide investment, tax or other advice to you or any other party, and no information in this document is to be relied upon for the purpose of making or communicating investments or other decisions. Neither the information nor any opinion expressed in this report constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service.
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NOTE: (!!!) MISSING EXTRA PAGE AND THEREFORE FOOTNOTES

StepStone Group (Nasdaq: STEP) is a global private markets investment firm focused on providing customized investment solutions and advisory and data services to our clients. StepStone’s clients include some of the world’s largest public and private defined benefit and defined contribution pension funds, sovereign wealth funds and insurance companies, as well as prominent endowments, foundations, family offices and private wealth clients, which include high-net-worth and mass affluent individuals. StepStone partners with its clients to develop and build private markets portfolios designed to meet their specific objectives across the private equity, infrastructure, private debt and real estate asset classes.

W. Casey Gildea
Managing Director casey.gildea@stepstonegroup.com
+1.212.351.6114

https://www.stepstonegroup.com/
450 Lexington Avenue, 31st Floor
New York, NY 10017

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StepStone Group

W. Casey Gildea
Managing Director casey.gildea@stepstonegroup.com
+1.212.351.6114

https://www.stepstonegroup.com/
450 Lexington Avenue, 31st Floor
New York, NY 10017

View the contributor page