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Farmers have only one true absolute constraint to growth … their time. For farms with good track records, access to capital was not a problem. But, in the future, how farms will be capitalized and where that capital will come from may be changing.
A group of leading farmers, recently when asked to rank the top risks they think they will face in the next 18 months, listed access to capital as fourth, just narrowly behind counter party risk, which the risk taken on when entering into a contract to purchase an input or sell a product where delivery of the product or receipt of payment is deferred. They listed managing margin risk, input access as one and two and interest rate risk at number five.
At a recent conference, a major U.S. lender cautioned farmers not to take credit for granted. He said lenders might not be able to control ag cycles and related volatility but can limit risk through careful customer selection.
Lenders have extensive research data on their farm customers and have learned that the most predictive performance data, in rank order, are:
The prediction of risk varies with loan size and type of operation with the predictors even more closely associated with larger operations. The more focused the customer is on primary agriculture, the more important it is to have stronger working capital and equity positions.
He stressed the increasing focus on a farmer’s demonstrated capacity to repay obligations. Security is important, but with rapidly escalating real estate values, it is challenging to pin a ‘real’ value on the security. This particular institution’s procedure is to take average land values for 2006 and 2007, then divide the averages by two and use that as a basis for the amount lent using land for security. He indicated that lenders may be, if they not already are, willing to walk away from good quality business.
Let’s take a look at the working capital issue. Do you … should you … tie up your working capital to purchase next year’s inputs a year in advance? This requires some significant consideration. By doing so, you inherently share some of the liquidity risk (the ability to generate the positive cashflow needed to operate a business) of your supplier. Canadian chartered banks are struggling with this scenario as well. How do they provide operating credit for next year’s crop let alone for the current crop, given the run-up on input prices and the need for crop financing? How do they secure the credit that they offer? They believe that a significant part of the answer rests with the farm management team. Has management demonstrated, not only the historical capacity to repay obligations, but that they are advancing their management skills; keeping pace with the current industry environment?
This becomes even more challenging for farms with growth objectives. Where is the capital going to come for the growth? Typically, it has been a combination of owner capital (in the form of cash and/or equity in assets) and leveraged or debt capital. There are options to this model. There are examples of farm businesses whose objectives are to increase productive assets by means other than ownership, optimizing return on the capital being used primarily for operations. They are using other investors’ capital (fixed assets) in exchange for opportunity to participate in a larger business model. It’s the structure of the arrangements is what sets these models apart from traditional rental agreements.
There is also some interest in equity injections from arm’s length investors. This is relatively new to the grain/oilseed sector. The interest is partly due to the perception that relatively good returns now exist in the sector. If your farm has been really profitable, and you think this will continue on for an extended period of time, outside equity as a source of capital can be expensive … expensive being the cost associated with the investor getting the same return you are getting on your equity; likely significantly greater than debt capital (interest rates). This arrangement can also be expensive in the event of a downturn in the industry. Any farmer fully understands the risks associated with their business and likely will be prepared to weather through an extended down turn. But will an equity investor be as committed?
Are there alternatives to how your farm business could be financed? If so, what are the related cost / benefits? Assess your major lending relationship. Does your lender understand your business and where it’s going? If not, present him/her with a plan.
Financing farms with debt capital has largely been a least cost exercise. There are indications that this may be changing. What will your business strategy be in terms of accessing the capital you’ll need?
Terry Betker is a partner with Meyers Norris Penny LLP, working out of the Winnipeg, Manitoba office. He is director of practice development in Agriculture – Government & Industry. He can be reached at 204.782.8200.
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