U.S. Rural Infrastructure Opportunities Fund – Will It Help or Hinder?

Written By: William M. Fitzgerald, CFA
Thomas Erdman

August 29, 2014

Preface

The White House Rural Council announced its plans to start an investment fund called the Rural Infrastructure Opportunity Fund that will give pension funds and large investors the opportunity to invest in infrastructure projects that support the agriculture industry. The purpose of this program is to encourage private investment in the rural communities that are the agriculture sector of the U.S. economy. CoBank, which is a cooperative bank and a member of the Farm Credit System, has committed the first $10 billion to the fund. Capital Peak Asset Management will manage the fund's investments and the Agriculture Department will source projects for the fund. Investors will be able to make debt and equity investments in individual and bundled projects.

Our concern with this program is that it assumes that all that is required to advance the agriculture industry in the United States is to give investors a little nudge to send capital to an "overlooked" investment opportunity. However, policy makers fail to understand that investment capital flows to any sector that offers a competitive return. It is not access to financial capital that is the problem for the agriculture industry, but other factors that unfavorably influence the markets for agriculture products and discourage investments in infrastructure that would support the industry. These factors include (1) the economics of the agriculture sector, (2) the failure of policies to manage the natural capital consumed by the sector, and (3) the lack of synchronicity of policies that could, if properly aligned, encourage investment capital without the need for a "nudge" from government.

Economics of the Agriculture Sector

The first conclusion that investors draw about agriculture businesses is that they are not very profitable. The primary reason is that prices of agricultural products have not increased as quickly as the cost of fuel required to operate machinery and transport products to market. During the twenty years between 1993 and 2003, the prices of corn has increased by 177%, wheat by 128%, cattle by 84% and milk by 54%.1 By comparison a barrel of Brent Crude oil increased by 568% during the same time period. The compression of operating margins of farming businesses is one of the significant drivers of consolidation in agriculture.

Supply and demand in the market for agriculture products in the United States is significantly influenced by federal government policy. In total, the U.S. Department of Agriculture will spend $149 billion in 2014 through 240 subsidy programs2. A number of these programs, totaling approximately $22 billion, encourage the supply of agricultural products to make food affordable to American households, including:

Direct payments to farms that produce crops such as wheat, corn, barley, oats and cotton, typically totaling $5 billion annually; Non-recourse loans up to $7 billion annually to farms that produce these and other crops, allowing borrowers to deliver the crops rather than repay the loan should loan amount exceed the value of the crop; Direct subsidy payments to farms when prices of agricultural commodities drop below specified levels, totaling between $1 billion and $4 billion annually in subsidy depending on prices; Subsidies for crop insurance totaling $4 billion that allow farms to pay as little as one-third the market rate for such insurance; A government guarantee to acquire any excess cheese, butter and non-fat dry milk that a farm produces in a year; and Monthly payments to milk producers when prices fall below target levels.

The effect of this array of policies is to systematically create an oversupply of agricultural products, which inadvertently reduces the pricing power and profitability of farms and small businesses in rural communities that support them. The lack of profitability keeps investors for allocating capital to agriculture businesses.

Failure of Policies That Manage Natural Capital

Water is important to both farms for irrigation and to food processors for production. But the state and federal policies that organize the use of this shared resource have not encouraged private investment. For example, the Colorado River is a primary source of water for agriculture businesses that are located in the seven Western states through which it traverses, and is an important source of drinking water for urban centers that include Phoenix, San Diego and Los Angeles. In 1922, the states of Arizona, California, Colorado, Idaho, Nevada, New Mexico and Utah agreed to an appropriation system that divides 16.4 million acre feet annually, even though only 13.5 million acre feet passes the river in an average year3. The appropriation doctrine states "first in time, first in right," which means that someone with a higher priority allocation must use it for a beneficial purpose or lose the allocation to someone with a lower priority position. While a market exists for selling allocations, the law restricts the sale of excess water to 20% of one’s allocation. This creates a distorted market for a critical natural resource. Water from the Colorado River is virtually free for those with priority rights but can be extraordinarily expensive for those with no or low priority rights (one acre foot was recently bid at $22004).

By underpricing water to the "firs in time," this policy has encouraged excess demand for a finite natural resource. According to a recent study by NASA and the University of California at Irvine, the Colorado River Basin has lost 53 million acre feet of water during the past nine years due to elevated consumption during the recent drought5. Local governments are working to solve the shortage of water by planning infrastructure to store and transport excess water and to treat wastewater for re-use. If a free market accurately valued water from the Colorado Basin, local governments could easily offer an attractive financial return for investments in water infrastructure to those who provide capital in the private market without any incentive or "nudge" by government.

Lack of Synchronicity of Policy

We have seen examples of how local policies for managing wastewater provide disincentive for investors to provide capital. One example is the policies of the State of Wisconsin for managing the waste that food processing plants generate. Food processors commonly produce liquid waste that contains high concentrations of phosphorous, which is a valuable ingredient in fertilizers used to increase the production of many crops. Many food processors receive licenses from the State to spread this liquid waste on farmland, an arrangement in which the food processors merely pay the cost of transporting the waste in trucks. However, when phosphorus is spread on farmland in liquid form, it can run off into local tributaries and lakes and create algae blooms that damage sources of drinking water. The City of Toledo, Ohio recently banned users of its water system because of such an algae bloom in Lake Erie, its source of drinking water.

Alternatively, food processors can dispose of their waste at treatment plants that are able to separate the phosphorus and other contents that may be harmful to the habitat. But unlike the food processing companies, the State imposes specific limits on the amount of phosphorus that may be present in the water that a treatment plant discharges. A treatment plant can remove 90% of the phosphorus in the waste of a food processor and still not meet the standard for the removal and be subject to a fine. Moreover, the treatment plant will have removed and stored a substance that would otherwise harm the local habitat and receive no financial benefit from this activity. Such policies lower an operating expense of the food processing company while increasing the operating expense for the waste treatment plant. By narrowing the operating margin of the waste treatment plant in favor of widening the operating margin of food processing company, the government has encouraged private investment in the food processor at the expense of the infrastructure project. No new government program can "nudge" investors enough to compensate for this type of distortion. All government needs to do is properly align its policies – assess fees to the food processor that threatens the source of drinking water and provide financial benefit to the treatment plant that removes the harmful waste.

Conclusion

Seven years ago, the federal government of the U.S. encouraged private financing of ethanol producers by requiring refiners to blend ethanol into vehicle fuel, creating demand for the additive and offering an incentive to attract investors. Recently, the EPA reduced that mandated blend by 12%, which will cause up to 20 ethanol plants to close6. The economics of ethanol didn't support its use in vehicle fuel, so "nudging" private capital to invest in the industry invited them to lose their money.

We believe that investment in infrastructure must balance the goals of government policy and the underlying economics of industry. It must balance the benefits that local economies produce, such as products and jobs, and the natural resources that they consume, such as water. The examples we describe above demonstrate that a lack of balance leads to the loss of both natural capital and financial capital.

Notations:
1. Farmdoc, University of Illinois at Urbana-Champaign, www.farmdoc.illinois.edu.
2. Edwards, Chris, "Downsizing the Federal Government," CATO Institute, June 2009.
3. Gelt, Joe, "Sharing Colorado River Water: History, Public Policy and the Colorado River Compact," Arroyo, August 1997, Volume 10, Number 1.
4. "Profiting From California’s Epic Drought," Bloomberg Businessweek, August 11 – August 24, 2014.
5. "Satellite Study Reveals Parched U.S. West Using Up Groundwater," NASA, July 14, 2014.
6. "Ethanol Mills Face Closure as Obama Cuts Target," St. Louis Post-Dispatch, December 4, 2013.

Do Infrastructure Funds Deliver?

According to Preqin, a research firm that investigates the private equity financing market, investors in infrastructure have poured $195.6 billion into unlisted infrastructure funds since 2004.  The marketing materials that promote these funds commonly discuss two benefits:

  1. Diversification of the equity risk that is often present in the portfolios of sophisticated investors; and
  2. Hedge against the risk of inflation.

The fund promoters say these benefits accrue to investors because economic value of infrastructure projects are not driven by factors that commonly impact growth in the economy and the enterprise values of companies that commonly finance their activities in the equity markets.  The projects are essential to the daily operations of households and businesses and their revenue contracts are often tied to changes in aggregate price indexes such as the Consumer Price Index in the United States.

We are nearly ten years on in the financing of infrastructure projects in the private market.  Do these investment funds deliver the investment outcomes that they promise?

To address this question, we conducted regression analyses of the total returns of two infrastructure funds that invest in listed infrastructure: Fund A is a mutual fund sponsored and managed by a large U.S. fund company and Fund B is a closed-end fund traded on the NYSE that is sponsored by a U.S. fund company and sub-advised to the largest private equity manager in the infrastructure financing market.  If the investment strategies were to accomplish what they advertise, we would expect to see a low correlation of the funds’ investment returns to the returns of the S&P 500 and a high correlation to the Consumer Price Index.  We found the opposite.  The total returns of the funds were highly correlated to the S&P 500 and not so well correlated to CPI.   We offer greater detail in our report What Really Drives the Performance of Infrastructure Funds? posted on this web site.

We recommend that the sophisticated institutional investors who have committed nearly $200 billion to infrastructure funds critically analyze the nature of the returns that they are receiving.  Our conclusion is that they are capturing the beta of the general equity market and doing so with an expensive private equity fee structure.

-William M. Fitzgerald

Researched by Kelsey Smith

October 18, 2012

 

A Referendum on Infrastructure in the U.S.

On July 31st, local governments in Georgia asked the permission of its voters to levy an additional 1% sales tax to finance a total of $18.7 billion in infrastructure projects within the state.  The list of projects represented a collection of priorities submitted by each of the State’s twelve Regional Planning Districts, created by State’s legislature to prioritize and finance infrastructure in Georgia.  Three quarters of the proceeds of the sales tax would fund the list and the remaining quarter would be diverted to local governments to finance their own infrastructure priorities.

The initiative was soundly defeated in nine of the twelve Regional Planning Districts.  This outcome is troubling for a number of reasons:

  1. Lack of fiscal stimulus.  As described in a paper posted on this web site, “Why Invest Infrastructure”, Xue Han estimates that the fiscal multiplier effect for spending on infrastructure projects is at least 50% higher than that for other forms of government spending.  The reason for this is that a smaller proportion of such expenditures leak out of the economy through imported goods, keeping the economic benefit within the local or regional economy.  Georgia voters opted against such economic stimulus;
     
  2. Lack of feedback from voters.  Other than express a strong preference to live without the list of infrastructure projects, government officials have come away from an expensive election process with little useful information about what their constituents would like for them to accomplish.  Did voters believe the costs outweighed the benefits?  Do they prefer a greater tradeoff with environment concerns upon which the projects would infringe?  Do voters prefer locally planned projects over those planned by counties and regions?  Are they more likely to spend on smaller projects with more tangible benefits to them?  Did they believe they had sufficient information to evaluate the list of projects prior to casting their vote?  State and Regional administrators have answers to none of these questions.
     
  3. Lack of an effective approach.  In most states, elections allow voters to decide who in their governments will identify priorities, conduct analysis of the cost and benefit of infrastructure projects and decide the initiatives that government will fund.  Some states take the election process a step further and invite voters to decide how their tax dollars are spent and on what.  The latter approach of “bring it to the voter” makes it difficult for government to address longer arc problems like managing traffic, building or expanding transportation links and corridors, supplying sources of energy to local economies, etc.  The extreme form of voter involvement is the government of California, in which voters have agreed to a potpourri of initiatives that don’t fit within a cohesive vision and plan for how the voters will live and work in years to come, and ultimately create budget gridlock.

While many Americans are currently expressing their preference for a smaller and less expensive form of government, it is important to remain open to the value of employing professional managers to plan and execute initiatives that benefit the common.  When presented a list of infrastructure projects without the context of a long term plan, voters will never find themselves in the position to make the planning decisions that professional managers of government can make.

 

-William M. Fitzgerald

September 28, 2012