Core Supply Chain Investment as Launching Platform for Outlier Farm Enterprises – Part II

Case Studies

Mar 24, 2010 — Neil Boyle

Part I asserts that wise and patient capital are important ingredients to getting outlier farmer contracts right, but does not go into details. The subject of wise capital is addressed in two website postings, namely: the Part I version of this paper, and Project Finance: Incentives and Governance.   The topic of patient capital is addressed below.  This is Part II of a series that will address this issue in greater depth. 

Operationalizing patient capital boils down to this question, How can the performance of long-term debt maturities be assured in the face of uncertain farm program execution?  Long-term debt is needed to grow the appropriate scale and competence of small scale outlier farmers to attain sustainability.  Outlier farmers and their outlier farm managers need steady and reliable technical and financial support over this period during which much can and will go wrong. This makes the practical assumption that farmers are centrally coordinated and assisted by a farm manager who also may assume a portion of the financial risk of the project. The situation is exacerbated by the pre-emptive security feature of debt finance held by creditors and this is exacerbated by the economic uncertainty of outlier farm programming. Pre-emptive debt security: (i) takes program discretion out of the hands of the outlier farmer manager/investor and places it with the commercial bankers; and (ii) it creates the difficulty of autonomous bilateral trading (discussed earlier) among contracting parties. And outlier farm programming is uncertain because the absorptive capacities of autonomous farmers are stochastic.

Recall from Part I that supply chain operations break out into core and outlier operations in that order.  For practical design purposes, outlier operations are a function primarily of core operations in financial and technical terms. The security of patient outlier capital is dependent on optimizing the operations of the core on both fronts. The stronger financially and technically adaptive the core, the more successful the outlier operations will be by gaining the time that is  required to adapt technically to the new cultivation protocols (explained later). Building discretionary flexibility into core operations comes down to two foci (i) acquiring a robust debt-equity cushion and strong cash collateral to support the long-term debt maturities that are needed; and (ii) establishing a credibly committed relationship (discussed elsewhere) with creditors as this will maximize both technical and financial discretionary flexibility.

Core operators, therefore, need to build up a strong debt equity cushion and strong cash collateral to support subsequent loans under tough stress test conditions for outlier operations.  Financial strength of the stable and resilient net cash flow variety as well as capacity to develop deep creditworthiness and leverage levels that won’t yield excessive managerial discretion to creditors should be criteria for selection of the supply chain investor. A capital adequacy hurdle rate also should be part of this selection critierion. Managerial strength of core and outlier farm managers should also form part of the investor selection criteria especially capacity for adaptive ingenuity and private ordering qualities related to contracting and contract management. Outlier farm managers will need to work closely with core managers as not all outlier farmers are likely to make it through the first round of available feasible financing and plans should be made to accommodate a second round of financing for second rounders.  

Outlier operators, therefore, need to place strong emphasis on team learning farm clusters and true-to-life-simulation training and preparation for field trials. Team learning will help farmers assist other team farmers as technical cooperation, demonstration activities, and technical capacity building are regular features of contract farming. Simulation training will introduce farmers to the demands of contract farming and in particular the methods and procedures for staying on the contract curve, i.e., the cultivation protocol. Field trials are designed to develop performance based cultivation protocols that are stratified and ranked according to farmer capacities. Once these protocols are developed for different farmer capacity sub-groups, cultivation protocols should be honed to match farmer group rankings with the feasible set of ranked debt-equity financing arrangements under different core operating conditions. As mentioned earlier, not every farmer is likely to make the supply chain hurdle in the first round leaving the opportunity open for the persevering farmer to try again. Farmer technical capacities are unlikely to be contiguous with the land ownership patterns of selected outlier farmers so that cost and benefit adjustments are suggested.

At best, traditional analysts note that outlier farmers are long-term contractors, hence contract design and implementation are important strategies for mitigating program uncertainty.  What analysts may gloss over, however, are first, that these contracts are incomplete and therefore superior contract design needs to take incompleteness into account; and second, that these contracts are front (exante) loaded and superior design emphasizes contracting-in-its-entirety. Contracting-in-its-entirety includes the entire contract cycle of before contract signing, i.e., exante, and of after contract signing, i.e., expost.

Taking incompleteness into account addresses the issue of contract hazards.  Hazards are embedded in all agreements and contracts.  Even after negotiating away all so-called risks, contract hazards comprise (in technical language) “asset specificity or holdup; incomplete contracts and residual rights; and moral hazard and plasticity. Expost costs can affect exante choice of technology.” (Williamson, 2003).  Hidden risks exist even after negotiating a high productivity or high performance contract.  Another way of looking at hazards is that they are the hazardous incentives or the risk factors that cause risks to occur.

Contracting-in-its-entirety addresses the issues of “poverty of stimulus.” PPP contract agreements are unstable due to contract parties drifting off of the contract curve. Getting on the curve is relatively easy as incentives to reach agreement are strong in the highly charged early stages of contracting but notoriously weak for staying on the curve over the long-haul of implementation, which is the most difficult part of contracting. This is due to a “poverty of stimulus”. While contract designers pay attention to getting parties to reach agreement, contract managers are frequently deficient in keeping them there; to do so takes managers of the adaptive ingenuity kind.

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