China agriculture: Seeds of hope
Asian Venture Capital Journal | 19 August 2015
Whereas previously farmers typically held their land through long-term, non-tradable land use contracts allocated by the local government, now they are able to sell these rights. Black Soil Capital Partners wants to collect up the contracts, delivering a cash windfall to the farmers and creating a larger tranches of land that can be worked more efficiently. Above, Chang Sun, founder of Blck Soil Capital Partners.
China agriculture: Seeds of hope
by Winnie Liu
Fragmentation and inefficiency have hampered Chinese agriculture for years, but a combination of policy reform and consumer demand may allow the sector to unlock its potential. Does private equity have the key?
The black soil found in the northern China province of Heilongjiang is famously well-suited for farming. It has become the country's most important commercial grain base, accounting for one-fifth of the annual yield for crops such as corn, soybean and wheat.
Chang Sun, formerly Asia managing director at Warburg Pincus, drew on these rich fields for inspiration when coming up with a name for his newly-formed private equity firm. Black Soil Capital Partners is now seeking to raise as much as $1 billion for a fund that will invest in China agriculture opportunities.
The fund, which would be by some distance the largest of its kind, comprises two vehicles - one in US dollars and the other in renminbi, each with a target of $500 million. Central to the investment thesis is a desire to address the fragmented nature of Chinese agriculture, which is responsible for the sector's inefficiency and low productivity. If Black Soil gets its way, the fields of Heilongjiang will be consolidated under long-term leases from farmers, giving way to a modern, industrialized US-style business model.
Few if any private equity firms have set out to invest in Chinese farmland - they tend to focus on agricultural inputs, equipment and supply chains as a means of improving productivity. But Black Soil's strategy is very much in keeping with government policy and primed to take advantage of an economic transformation already taking place in rural China.
"The central government has recognized that the agricultural sector isn't competitive internationally, partly because the yield in domestic production is still not up to international standards," says Wayne Batwin, a director at PRIME Market Access International who was previously with the US Department of Agriculture's trade office in Shanghai. "For example, the US is generally are 2-3 times more productive than Chinese players in areas like soybeans and corn."
About one third of China's 1.4 billion population live in rural areas, but the demographics are changing. Many young people have migrated to cities, reducing productivity on farms and raising concerns about the future basic food output. At the same time, there is rising demand for better quality food from middle class consumers. Clearly there is potential upside for investors who can find ways to make the agricultural sector operate more effectively. But where should PE players start?
Black Soil's land consolidation angle is a pertinent one. In China, the average farm is about 1.5 acres in size and family-run, while the US is characterized by corporate farming and the average size is in excess of 400 acres. It is difficult to be internationally competitive when unable to access the economies of scale afforded to others.
In January, the central government listed food safety and farmland modernization among its key priorities in policy initiative called the "number one document." Whereas previously farmers typically held their land through long-term, non-tradable land use contracts allocated by the local government, now they are able to sell these rights. Black Soil wants to collect up the contracts, delivering a cash windfall to the farmers and creating a larger tranches of land that can be worked more efficiently.
But dealing with the local authorities that remain ultimate owners of the land can be challenging. "Officials may have some other ideas as to how they want to use the land, and they will put pressure on farmers to use it in a different way. This is why trying to increase the size of production areas by combining small pieces of land is difficult," says Batwin.
Another potential problem is the return horizon. While large institutional investors are willing to make long-term investments in farmland in developed markets globally, such assets are not necessarily a good fit for a traditional private equity manager who needs to start exiting a portfolio within seven years, particularly when harvests for certain crops can be volatile. In addition, recruiting farmers to work on the farms and making sure they grow the crops in a standardized way is a lengthy process.
"It's not about capital appreciation on the farm lands; it's about earning money from the harvest, and this means managing a lot of farmers. We would much prefer to invest in a company making concentrated apple juice than buying some land for apple plantation. It's much easier to manage a factory than to be the village chief," says Chong Min Li, co-founder of CMIA Capital Partners.
However, land reforms are being implemented. In response to the central government's guideline, Batwin is seeing Chinese entrepreneurs - not individual farmers - who have relationships with local governments, take the lead in discussions about land consolidation. It is possible they will look for private equity or foreign strategic support in bringing in new technology required to scale operations.
In this context, reform doesn't only create an opening for private equity as consolidator. Companies all along the agricultural value chain could benefit, from fertilizer producers to agricultural machinery makers.
International Finance Corporation (IFC) and Agricultural Fund of China (AFC), a state-backed agricultural fund launched by The Chinese Academy of Agricultural Sciences, see fertilizer as the ideal proxy. Not only does fertilizer contribute directly to improvements in farm productivity, but the manufacturers want to invest in scaling up their own operations to capitalize on the opportunity.
"We are looking at a fertilizer company that has a contract for a big piece of farm land in Shandong province. This means it can conduct more R&D in order to improve the efficiency of its products based on soil quality and reduce marginal costs through scale production," says Chunyu Guo, an investment manager at AFC. "But we have been very careful in selecting companies because some of them have no real grasp of the technology side."
In an ideal scenario, one of these newly-created large-scale farms would be able to buy custom-made fertilizer and other inputs in bulk, thereby achieving economies of scale; invest in biotechnology and supporting infrastructure such as piped water to increase crop yields; and harvest and process using top-end machinery from the US or Europe; and retain a larger slice of the profits by managing its own distribution instead of relying on countless middlemen.
Even in southern China, where the climate and topography make US-style industrialized farming more challenging than in the north, technology can find a way. CMIA-backed Hunan Zhongtian Longzhou Agricultural Machinery, which specializes in making equipment for the muddy southern terrain, is one of many examples of Chinese entrepreneurs taking Western technology and adapting it to local needs.
At the same time, CMIA's Lee cautions that the ideal scenario is not yet a wholly realistic scenario. "Technology is interesting but most Chinese farmers aren't rich; they can't afford to buy it without government subsidies," he says. "In addition, many of them aren't sophisticated enough to understand new things. Even if they adopt the technology to produce better quality rice, they don't know how to market the products differently. Investors have to watch the pace of the development in this sector."
This dynamic also places greater emphasis on the nature of their value-add. Black Soil, for example, has bought in operating partner David Liu, who was previously China country manager at DuPont Pioneer where he worked on promoting hybrid seeds to improve crop yields. He is expected to help farmers understand the technology at their disposal.
Hailun Zhou, a partner at China New Enterprise Investment (CNEI), states there are two key areas in which private equity can add huge value: seeds and animal breeding, both of which have a direct impact on productivity.
CNEI has backed one seed specialist and two animal breeding companies, and a common characteristic of these investments is the contribution to an integrated approach to farming. It is particularly apparent in animal farming, where there is a desire to control everything from what livestock eat to how the meat is transported to the distributors.
The integration game
Vertical integration features in all of KKR's high-profile investments in the sector. It was part of the thesis when the firm backed China Modern Dairy in 2008, seeing the value consumers would place on a secure supply chain. Integration was also a factor in the Fujian Sunner Development deal last year: Julian Wolhardt, head of the Greater China PE team, told AVCJ that Sunner is the only fully integrated chicken producer in the country and he wasn't sure KKR would have backed any other company.
The unifying element is safety, an issue that taps into the concerns of all middle class consumers. "Plantations are becoming less important and animal farming is becoming more important. It is responsible for about 60% of total agricultural outputs in almost every country," adds Alex Zhang, CEO of Hosen Capital.
The food and agriculture specialist, which counts domestic agribusiness conglomerate New Hope Group as an anchor investor in its funds, is understood to be seeking $400 million for its second US dollar-denominated vehicle. Investment targets will range from agricultural inputs through processing and manufacturing, logistics and retail to consumer goods.
Zhang identifies the latter half of the chain - getting products from farm to processing plant to supermarket shelf - are particularly attractive. Local demand for high quality meat prompted Hosen's purchase of Kilcoy Pastoral, one of Australia's leading premium grain-fed beef processors and exporters. China's deficiencies in food processing and packaging technology led to the subsequent bolt-on of US-based processor Ruprecht.
On the distribution side, private equity investors are flocking into cold chain logistics. The same safety and quality concerns are relevant in this space, but demand has been accelerated by the e-commerce boom in China. Consultancy Roland Berger estimates that RMB400 million in products requiring cold chain logistics - such as premium meats and seafood - were purchased online in 2012.
"China's cold chain isn't really up to the quality but it's progressing very quickly. It's a huge sector, worth between $500 million and several billion, in terms of the supply chain for food distribution. And the internet is already changing it dramatically, helping integrate the upstream and downstream," Zhang says.
The cold chain market as a whole is expected to be worth RMB470 billion by 2017, yet in terms of the broad agriculture sector this is a tiny sum. It is near impossible to capture the scale of transition taking place on China's farms and the various suppliers and distributors that tap into the value chain at different points. Progress is slow, and this should be factored into investment horizons, but even small ripples created by a new technology or policy initiative can have sizeable repercussions. For example, in the last five years the percentage of pig farms with more than 500 head has risen from 10% to over 60%.
"While there is a wide technology gap in animal farming between developed countries and China, it is narrowing," says Wei Lei, an investment officer at IFC. "We are seeing more Chinese corporations bringing in overseas technology. There is a clear trend for Chinese upstream farming to become more concentrated and institutionalized, and this supports the entire value chain upgrade."
Sidebar: Empowerment - Technology and rural consumers
Close to half of China's population was online by the end of 2014 - and most of them via mobile phone - as the total number of internet users reached 649 million. Penetration drops to 27.5% in rural areas, but these locations are still home to just over one quarter of total user base.
For large e-commerce players like Alibaba Group and JD.com, which largely focus on upper tier cities, smaller urban centers and rural areas represent a huge untapped market with an estimated population of about 400 million. Over the last two years, the companies have intensified efforts to expand their internet-based services into China's hinterlands.
"We have the impression that [Alibaba's] Taobao and TMall are everywhere in China. The reality is that a large portion of Chinese population has not been touched by these platforms. When you go to small townships, the logistics are still not there. So JD.com and Alibaba try to partner with stores in small towns to improve their logistics services," says Jixun Foo, managing partner at GGV Capital.
These emerging internet users also present a new set of opportunities for VC investors, as the needs of rural consumers differ from those of their urban counterparts. For example, taxi-booking apps Didi Dache and Kuaidi Dache are widely used in top tier cities but less relevant to farmers. Shunwei Capital Partners recently identified the rural internet as a key theme for its new $1 billion fund, while the likes of GGV are also looking at potential investments.
"One area of interest is agricultural supply. The sector is very broad and also highly inefficient, all the way from farm production to crop distribution," Foo adds. "There are already online marketplaces that connect farmers and restaurants for trading purposes. It's not just about consumer internet; it also business-driven."
In March, Chinese Premier Li Keqiang announced "internet plus" policy in an attempt to rejuvenate traditional industries by grafting modern technology onto tired business models. Earlier this month, Cloud Farm, an online agricultural products shopping mall, raised nearly RMB100 million ($16 million) in funding from domestic GP Chunxiao Capital, having previously received funding from Legend Holdings.
The platform, which offers more than 2,800 agricultural products, such as fertilizers, pesticides and seeds from 400 supplies, is intended to improve efficiency and cut down costs through integrating upstream and downstream operations. Cloud Farm has created a network of more than 300 centers in counties and 25,000 village service stations across 13 provinces to take orders, process payments and make deliveries.
On the consumer side, there is Huitongda, which sells home appliances including TV and refrigerators online. The five-year old start-up was founded by Jianguo Wang and Xiuxian Xu, who previously created Jiangsu Five Star Appliance, an offline electronics retailer that was sold to US giant Best Buy. Huitongda recently raised a RMB500 million ($80 million) from New Horizon Capital and Addor Capital, a PE firm owned by Govtor Capital.
Rather than relying on Alibaba's Alipay system to manage payments - the channel of choice for most urban residents - the company uses UnionPay and accounts with Agricultural Bank of China. The offline element sees Huitongda work with more than 8,000 small stores in seven provinces.
"The opportunity in the rural internet sector is huge," says Joe Zhou, investment manager at Addor. "Last mile delivery from county to small town is very difficult, especially for large electronic items. In addition to logistics, Huitongda can also offer cheaper prices as well as installment and maintenance services to rural users."
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