Local Government Pension Scheme funds must be constantly vigilant for new opportunities as returns and yields in some traditional asset classes are stagnating.
Although they maintain a core portfolio of equities and bonds including gilts, funds are increasingly looking to alternatives such as private equity, infrastructure and other real assets that can help them meet their investment objectives.
LGC’s January roundtable, supported by Insight Investment, examined the suitability of farmland investments for LGPS funds.
Mike Curtis, corporate director of finance and resources, Islington LBC
Rachel Dalton, features editor, LGC (reporting)
Sherilee Mace, institutional business development director, Insight Investment
Eoin McDonald, portfolio manager, Insight Investment
John Raisin, independent adviser, JRFS Pensions
Dawn Turner, chief pensions officer, Environment Agency
Bridget Uku, group manager - treasury and investments, Ealing LBC (chair)
Reza Vishkai, head of real assets, Insight Investment
Duncan Whitfield, finance director, Southwark LBC
The discussion chair Bridget Uku, group manager of treasury and investments at Ealing LBC, outlined the challenge facing LGPS.
“There’s a lot of uncertainty in markets, so you take more risk and get less return. We’re looking for where to get a better return,” said Ms Uku.
“The population is growing, so there is increased demand for food and we have a growing middle class that is eating better food. So farmland is one of those areas that could provide investment opportunities.”
Around the table, only one fund had actively sought to invest in farmland so far, but most had considered the asset class. Duncan Whitfield, finance director at Southwark LBC, said his committee had considered farmland around 18 months previously but had yet to buy into it.
However, he added: “We have a commitment to make sure [our investment strategy is] green, so the farmland opportunity is probably of interest to us.”
Mike Curtis, corporate director of finance and resources at Islington LBC, said his fund was also interested in the environmental sustainability element of farmland.
John Raisin, an independent adviser, said the three funds he worked with – Waltham Forest, Haringey and Barking & Dagenham – had invested more than the average in alternatives such as infrastructure and residential property, and that he saw farmland as a similarly compelling asset class. “There needs to be a further reduction in listed equities across the board,” Mr Raisin added.
“The average across the LGPS [in equities] is about 60%. I’ve always been an advocate of listed equities but there is too much risk on the table there. I’d see farmland as an asset that’s got that income element, that inflation hedge element.”
The Environment Agency pension fund has invested in farmland assets, as chief pensions officer Dawn Turner explained.
“About three and a half years ago we allocated between 5% and 12% to real assets: property, infrastructure, farmland and timberland; we have been successful in property and infrastructure and limited in success in agriculture and timberland,” said Ms Turner.
“The main reasons for that are not that there are not opportunities out there but often the price is too high, or we’re worried about some elements of sustainability or environmental, social and governance [concerns]. For example, with timberland there is a real struggle in terms of land-grabs [in which businesses force local people off land to buy it for large-scale agriculture] and that has stopped us on several occasions.
“On agriculture we have invested in California. The due diligence that we had to do on that was extensive. My chief investment officer went out to California to talk to [local] managers to ensure they understood about the position that they were in on the water [shortages] in California and making sure that they had covered that adequately.”
Ms Uku asked what the benefits of investing in global rather than UK agriculture were.
Reza Vishkai, head of real assets at Insight, said it was good practice to invest globally to diversify and spread the risks inherent in particular countries or markets.
He added: “We need to find the best places to invest. You need to look at the places that are producing more than they need and are in a position to meet the demand that is coming from China and parts of Asia and North Africa.”
Farmland in the UK, on the other hand, has some disadvantages, he explained: “The UK is a deficit country; 40% of what we consume here we import. The UK is actually quite an expensive country. If you buy land here you get a rental income of below 1%. It is 3% in the US.”
Mr Vishkai also added that the impact of Brexit on UK farming has yet to be felt.
Ms Turner said that there are also opportunities to invest in companies connected to farming to get exposure to the market. She cited businesses involved in the by-products of agriculture such as those processing and selling fruit pulps and juices and those distributing foods.
Ms Uku asked how funds can hold farmland assets if they are taking the direct route.
Mr Vishkai said investors could invest in farmland through managers who buy and lease out land, but Insight’s approach was to buy the asset and improve its earning potential over an eight to 12 year holding period.
Ms Uku asked how this compared with private equity-style investments. Mr Vishkai said it was a similar form of ownership but that Insight’s approach involved working much more closely with the underlying businesses for a longer period of time than in a private equity arrangement.
He explained that asset managers that buy and hold investments aimed for returns of 6-8%, split between rental income and land appreciation. However, when investors focused on value creation, they could aim for 10-12% returns.
“In Australia we bought a cattle station that had around 25,000 heads of cattle; we built that up to 40,000. It cost us A$300 per unit of increase, but the market today will pay us A$1,000 per unit of carrying capacity,” he added.
Ms Uku moved the discussion on to which vehicles pension funds can use to access farmland.
Mr Whitfield said pooling would affect the ways funds could access real assets. “Going into new investments that are not linked to pools [is not] a risk as such, but there are threats that basically say, that isn’t a long-term solution unless the pools pick up on those particular funds.”
Mr Vishkai said that private investments are currently exempt from the pooling requirements, but Mr Whitfield said the issue was still unclear and that pension funds were pushing for confirmation with the government.
However, Mr Whitfield added: “The real opportunity [for asset managers] is around the pools. If the pools are running with your ethically sustainable, socially responsible funds, then that’s probably our first go-to place as we move into new strategies.”
Mr Raisin said that pools would be likely to offer access to the asset managers that its member funds wanted: “If enough funds went into any particular product prior to pooling, pools should be offering those because the pools are agents of the individual funds. They are there to help [LGPS funds] execute their investment strategies.”
Ms Turner said that investing in farmland or similar long-term real assets could be easier within a pool, where funds could club together, than for funds individually.
“You need to [invest] at a certain level but that is unlikely [for an individual fund] because that would be a significant allocation to a specific asset class,” she said.
“Where funds say, ‘I really want to go into it but I don’t want to put £25m in’, the rest of [the funds in the pool] might want to invest as well and they could start to get comfortable with this asset class without taking too much risk.”
Ms Uku asked how funds investing in farmland could track ESG issues such as sustainable land use, animal welfare and the fair treatment of labour.
Eoin McDonald, portfolio manager at Insight, said sustainable and ethical farming practice went hand-in-hand with profitable business. “If you look at the best performers in the market, they will be the same people who are top performers in terms of ESG and responsible investment,” said Mr McDonald.
“Why? Because they’re maximising the profitability of their investment while protecting the underlying value of that asset.”
Mr McDonald said scientific breakthroughs have made sustainable and profitable farming much easier: “Farmers are now essentially a combination of businessman and a scientist.”
He added Insight’s fund had invested in a 14,000 hectare farm in Romania, where it had implemented conservation tillage farming practices designed to conserve soil, water and energy. This method of soil cultivation reduces soil erosion and water run-off and combats the very low levels of rainfall in the area. This has improved crop yields by 50% when compared to conventional tillage practices and has protected the soil structure, he said.
On animal welfare, Mr McDonald said Insight had been active in improving dairy farming techniques in their fund’s Chilean and New Zealand businesses.
“In the pasture-based dairy system, it is best practice for cows to calve down within an eight-week period and they’re in milk for an average of 280 days. A lot of farmers were inducing their cows to get them into milk early and this is bad practice. When we decided to invest in dairy herds, we outright banned inductions; we said this is an excuse for bad farming practices,” Mr McDonald explained.
He added that Insight brings in independent consultants to carry out environmental due diligence on its farm investments prior to acquisition, to look into issues such as asbestos exposure, effluent treatment and the management of soil nutrients.
Although more ethical and sustainable farming practices could increase the capital cost to the business, it can maximise cash yield by providing a unique selling point for produce, Mr McDonald said.
“Eighty-five percent of the world’s palm oil is produced in Indonesia and Malaysia. It has a notorious record in terms of deforestation and labour related issues,” he said.
“But there is a space in the market for sustainable palm oil, and then you say, ‘is there an opportunity there, where do I go to grow sustainable palm oil? Would I go to West Africa or South America?’ You would get a price premium for that because the Unilevers of the world would look to buy your production because it is produced in a sustainable way.”
The discussion then turned to the possibility of inflation hedging using farmland assets.
Mr Raisin said: “You would want to see with this type of asset a genuine income element of 3-5% to make it reasonable and realistic. That income element is one of the things that is going to bring down the volatility; that’s why commercial property is less volatile than listed equities because you’ve got the income element as opposed to just capital growth.
“You would be looking for a significant, reliable income element, which is hopefully linked to inflation, at least implicitly, which farmland would appear to give you.”
Mr Vishkai explained that farmland’s value was derived in some part from its link to the prices of its products – commodities – which are linked to inflation in the short-term, but that there was a long-term link as well.
“If you look at the long-term history of farmland, what you see in the 70-80 years to the end of the Second World War, farmland did not generate real returns. Afterwards you got very consistent real returns,” he said.
“So what was driving that? From the 1870s onwards the transportation infrastructure expanded drastically and costs fell. As a result, the geography of production grew as you didn’t have to be next to a transport hub where you could move your product. This meant that there was more land available so the real price didn’t go up.
“Since the 1940s this has stopped. Not only that, quality land has arguably been effectively shrinking. However, the amount of production coming from that land has been increasing. The real price of commodities has been collapsing, but the nominal price is going up. That combination of productivity increase plus the nominal price increase has consistently been greater than inflation now for 70 years, resulting in positive real returns.”
This trend was set to continue, he added: “Look at quality land, which is under more pressure now than it’s ever been. All of this new production has to be through greater productivity and the value of the land will increase. That’s the reason why the inflation linkage is actually very strong.”
With continued pressure on the LGPS to seek better returns and hedge against inflation, it is clear that LGPS funds will move further into alternatives including real assets over the next few years. The pooling initiative may help to make investment in real assets such as farmland – so often talked about – a reality.
Expert comment: Global farmland offers opportunity in real assets
Investors seeking the potential for income, real returns and diversification have increasingly turned towards farmland over the past several years. For funds in particular, new regulations promoting environmental, social and governance considerations as part of investment decisions align closely with an industry-wide initiative in farmland that seeks to embed responsible investment principles as core to industry practices.
Investors are increasingly driven by considerations around responsible investing and embracing the idea that such approaches can not only potentially enhance performance over the long term and are increasingly a pre-requisite for many corporate and individual buyers of agricultural products and therefore key determinants of success.
The core of Insight’s global farmland approach is based on Integrated Farm Management, a dynamic framework developed by Linking Environment and Farming, which provides guidelines for effectively balancing farming’s key objectives of productivity and profitability with environmental and other considerations.
Institutional investors and asset managers, including Insight, have been proactively looking to formalise guidelines for farmland investing in a global framework. They wish to foster greater transparency and to encourage investment in an asset class deemed to be of long-term interest to investors.
From an investment perspective, the key advantage of embedding these principles from the investment selection phase, through to the day-to-day management and execution, in our view is to enhance performance over the long term while mitigating downside risk.
Other characteristics associated with farmland investing, such as long-term growth and income dynamics, may make the asset class even more attractive to investors. In an environment where global inflation pressures are rising, investments that seek to generate real returns are likely to appeal. The inflation protection farmland provides is compelling and “inexpensive” compared to other alternatives, such as inflation-linked bonds. This is because farmland investments have demonstrated a high sensitivity to inflation due to the quick response of commodity prices to inflation.
The level of income from farmland may vary by commodity, region and operating model, but a well-diversified portfolio can potentially generate an attractive annual income, either through leasing out the property to operators or directly managing the assets. Farmland investments have substantially less correlation to economic growth than other assets, eg timber or property, and a global approach adds an additional layer of diversification. For this reason, we believe global farmland assets offer a distinct investment opportunity, particularly among real assets.
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