Research in Focus: Agribusiness schemes – what use are they?

There was a time when we would have said agribusiness schemes were of no use whatsoever in a portfolio.

And in a classical sense, that’s true. If you believe in modern portfolio theory, and therefore combining assets based on the patterns of their returns, agribusiness schemes don’t make the grade.

There’s no composite returns index for agribusiness schemes anywhere in the world that we can discover, and so no known correlation or covariance, and therefore no way of optimising agribusiness into a portfolio.

Furthermore, it is difficult to achieve agribusiness diversification for your average investor, because although they are ‘managed investments’ regulated by Corporations Law and theAustralian Securities and Investments Commission(ASIC), there are no agribusiness schemes that diversify across schemes (although Timbercorp has started down that track, with a scheme that allows investors to diversify across three crops — almonds, olives and eucalypt trees).

But agribusiness schemes are attractive for the immediate tax deductions they allow investors.

The solution? Agribusiness is dumped into that wonderful catchall — the ‘alternative asset class’ where research houses generally tell us it is acceptable to place up to 10 per cent of an investor’s portfolio. So why would you allocate to it?

What is the investor buying?

At the most basic level, an investor in an agricultural scheme is buying a deferred income and an immediate and ongoing tax deduction by becoming a primary producer.

But whereas start-up companies and primary production ventures have ongoing deductions and hopefully growing annual revenue, agribusiness schemes offer significant (up to 100 per cent of the investment) tax deductions in the first year and then may not produce income for a number of years. And the investor engages a manager to do all the work, whereas a start-up company or primary producer is usually ‘hands on’.

So agricultural schemes are most closely aligned with private equity investments, where there is a very close (but not hands on) relationship for the investor in the company they are investing in.

Agribusiness schemes invest in livestock, horticultural production or afforestation (and sometimes agricultural land).

In livestock schemes, the investor buys the animals and then pays regular costs and fees to a manager who looks after the stock and sells it when appropriate. The manager generally also profits by sharing in the sales proceeds.

In horticultural and forestry schemes, investors generally lend land that is used to grow a crop, paying regular costs and fees to a manager who is responsible for planning, maintaining, harvesting and selling the crop.

Net proceeds are distributed to the investor and treated as assessable income — but that income is often received many years down the track, whereas all fees paid are tax deductible in the year paid.

As ASIC points out “these schemes are not usually tax saved, just tax postponed”. And that depends very much on the manager sticking to the assumptions on which the ATO has given the scheme its product ruling.

Agricultural schemes can be categorised by the expected time frame when investors can expect to receive income:

* One to two years — wineries where fruit is purchased as well as grown;

* Four to five years — vineyards where fruit is grown and sold, and all berries/fruit (for example, coffee and olives);

* 10 to 12 years — timber for wood-chipping; and

* 20+ years — timber for furniture.

The shorter-term schemes, or ‘short-turn’ schemes, generally pay out management fees on an annual basis, accruing fees in the first years until the scheme is cash flow positive.

As most short-turn projects have a term of 10 years, they are akin to a higher risk, deferred investment nil RCV annuity with an upfront tax deduction. That is, there is no income flow for four to five years, and no terminal value, just an income stream.

In the long-turn projects, managers may profit share, taking a percentage of the sales proceeds. So these projects can be likened to a high risk, deep discount 10 to 20 year balloon payment, nil RCV product — or in other words, a purchase of an income payment to be received a long time in the future, with an immediate tax deduction.

What are the risks?

It is fair to say that agricultural schemes are more regulated than other managed investments, with both ASIC and theAustralian Taxation Office(ATO) keeping a close eye on them. Nonetheless, there are many risks, which fall into two camps.

1. Risks over income from the scheme:

* agricultural risks (weather, floods, droughts, fire and disease, access to water), which can devastate the crop/stock and the expected income along with it.

Some are insurable (and the insurance premiums tax deductible), and others can be managed through proper selection of plantation sites and crop species, and storage of water and so forth.

For example, a number of radiata plantations were destroyed in the Canberra fires and where owners were insured, they were compensated for the loss;

* economic risks, which can’t be insured against and which can affect the price received for the crop/stock when sold. For example, increased supply or the emergence of substitute products will depress prices, and currency fluctuations can affect the price paid for crops grown for export. Forward contracts are often employed to limit price risks;

* business risks, which again are uninsurable, such as manager failure in a compliance function (loss of licence), or as a business manager (poor cash management).

2. Risk that investors lose their tax deductions.

Product rulings were introduced in 1998 to provide more certainty for investors — in effect, a binding statement by the ATO with respect to deductions of fees available under current Australian taxation laws.

There are two risks. Firstly, if the scheme’s manager makes material changes to the expenditure, timing and establishment of a project, then the ATO can cancel the product ruling, and the tax deductions fly out the window.

Secondly, product rulings may be superseded by changes to tax laws.

ASIC’s view on agribusiness

In February 2003, ASIC published its Report on Compliance with Advice and Disclosure Obligations with repect to primary production schemes. It surveyed 103 responsible entities and found:

* low levels of compliance with the legal requirements regarding bookkeeping;

* difficulties in assessing whether sufficient capital is being maintained by responsible entities and is being contributed to core activities;

* responsible entities frequently outsourced important functions to often inexperienced managers or services providers; and

* the frequent appointment of related parties to perform extensive services to either the managed investment scheme or responsible entities with upfront payments for these services.

ASIC developed three recommendations that are worth keeping in mind when recommending agribusiness schemes to investors.

1.Managed investment scheme constitutions should set out in a comprehensive and clear manner investors’ rights and interest. The compliance plan should articulate how these rights and interests are to be established and the timeframe for these to be implemented.

The offer document should also set out the material arrangements in full to allow investors to understand exactly what rights they have, and to allow the ATO to review and ensure that the arrangements fit within the terms of any product ruling.

2. It would benefit investors if there was some form of consistent and standardised presentation of financial information, aligned to the process followed by industry standards.

In particular, where projections are to be presented, consideration ought to be given to whether all offer or disclosure documents might properly present projections about the pre-tax and ungeared basis in a consistent and standardised format to assist investors to assess the commercial soundness of the relevant project.

3. Except where the law already required disclosure of commissions that affect the return to investors, ASIC believes consideration might be given to the development of some form of industry practice regarding the disclosure of commissions in offer documents.

Reputable schemes

Despite ASIC’s negative view of the agribusiness world, there are reputable projects and promoters.

The number of research groups rating agribusiness schemes has increased significantly in recent years, and for the most part, the research is free to advisers, because the promoters pay the research houses to be rated.

It can be a struggle to collate reports on all projects, however, and compare them quickly and easily.

We recently published an Agribusiness Sector Review on the Portfolio Construction Forum, which presents a summary of 18 agribusiness projects that have achieved good quality ratings from Lonsec Securities’ specialist alternative research team.

The report is available free atwww.portfolioconstruction.com.auand includes timber, wine, grape, livestock, horticulture, olive and truffle projects.

The bottom line

Given the risks, we’d argue that agribusiness schemes are not a good inclusion in the portfolios of investors who need reliable income.

They may suit investors who can look on the potential income as a nice bonus if it eventuates, while enjoying the tax deductions along the way, and who understand that those tax deductions are vulnerable to the legislative winds of change.

Questions to ask about agribusiness projects

* Is there a clear commercial intent, that is, is the project intended to earn assessable income?

* Is there a known market for the produce, and will that market be available at commencement and until the end of the production period?

* Are there known pricing factors, and do they support the projected returns from the project?

* What exactly does the investor own?

* What is the net present value of any project return? What discount rate has been used?

* Are there any agreements in place with buyers for the commodity being produced? Are they on commercial terms and are they legitimate?

* What contingency plans are in place for continuous management? Has any money been put aside in case the manager fails?

* What assessable income, taxation and cash flow outcomes will occur over the life of the investment?

* What other entitlements (eg. conservation rebates) may be available to the investor?

* If there are carbon credits available, how are these to be allocated?

* Is the management and its associates reputable, knowledgeable, and experienced?

* Are there appropriate safeguards and management controls in place?

* Has the manager done the appropriate due diligence work?

* Is the project structured so investors are likely to obtain full tax benefits?

* Is the ownership or lease of the scheme land secure?

Deirdre Keown is with Brillient! and has been a funds analyst for the past 10 years.