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Assessing Vertical Integration as a Feasible and Profitable Business Strategy for Smallholder Agriculture

2024-01-10 Comments Off on Assessing Vertical Integration as a Feasible and Profitable Business Strategy for Smallholder Agriculture
Pedro Acte, 32, Nikté Alejandra Cú, 25, from Cacao Verapaz S.A., and Marisol Amador from Isidro, check the humidity of cocoa seeds in Lanquin, Alta Verapaz, Guatemala. Cacao Verapaz has vertically integrated and invested in their own collection & fermentation centers.

Agricultural cooperatives and small and medium-sized agricultural enterprises (SMEs) in the Global South commonly employ strategies of vertical integration. There are thousands of examples of cooperatives, across diverse geographies and crops, that participate in the production, processing and transport of agricultural goods. In many cases, these same agribusinesses also provide inputs and credit to their members or suppliers. International donors and development policy often support programs which assist cooperatives to integrate and capture more value. In the European agricultural space, EU policy provides rural farming communities with incentives to horizontally cooperate and vertically integrate.

However, the matter isn’t straightforward. Vertical integration can improve profitability and market power, but it is a risky strategy, especially for smallholder run businesses, as it increases management and administrative complexities, incurs additional operating and capital costs, and once started, it is a process which is difficult to reverse. The broader business and management literature on the topic of vertical integration is mixed and has shifted over the decades.[1]

How then can agri-finance and impact investors make sense of this uncertainty and tackle another one of the unique challenges of investing in agriculture? How does one differentiate between this large pool, of sometimes hard to distinguish, clients when making credit decisions? Given that 98% of the need for long-term agricultural debt goes unmet[2], one could surmise that most agri-finance players are not attempting to proactively answer this question.  Decision-making frameworks which have been empirically tested within the smallholder agriculture sector could help facilitate these investment decisions and improve the flow of capital to farmers and agribusinesses in the Global South.

Business Strategy or Necessity?

Larger agribusinesses sourcing from smallholder farmers often bind together several different links of their supply chain, within the same entity, to improve their market power and economies of scale. Benefits of integration include improved control over fragmented smallholder supply chains, especially production volumes and quality control, more efficient processing, cost savings on overhead, and direct access to end buyers. However, most agricultural cooperatives and many smaller agribusinesses are also exceedingly integrated despite revenues below $1M. For this class of enterprise, vertical integration is occasionally a business decision, but equally as often it is a necessity given the informal and unreliable nature of rural value chains in the Global South. Many cooperatives are compelled to integrate due to a dearth of quality service providers or contractors in the rural areas where they operate. If you are producing a perishable good in a rural region far from markets, with precarious infrastructure, it is imperative to have a degree of processing machinery, cold storage, and transport. If local banking institutions are hesitant to invest in smallholder agriculture, it is necessary to provide your farmer members with access to inputs, like fertilizer and seed, and to set up a microcredit portfolio to secure access to the required raw material.

However, due to their size, small or even medium-sized cooperatives and agribusinesses do not benefit from many of the upsides of integration -economies of scale, bypassing intermediaries, control- but they do have to deal with the cons: management complexities, high capital requirements, and multiple layers of compliance and regulatory bureaucracy. In the case of cooperatives, the goal of improving members’ welfare and paying higher prices to farmers, can limit the capacity to meet the financing obligations that come with capital expenditures linked to integration. The horizon problem, older members focusing on shorter term goals as compared to younger members, also limits cooperative’s openness to medium-term investments in capital. [3]

How then can investors adequately weigh the pros and the cons, and target agricultural SMEs with investment potential, while sidestepping those that are underprepared and/or overcommitted?

Staff at the food production plant PROSERESA in Guatemala City. Yummus Foods S.A. has decided to contract processing services rather than vertically integrating their garbanzo-based snacks business.

Decision-marking Frameworks for Investing in Smallholder Agriculture

In an attempt to answer the above query, I propose a set of criteria which could form the basis of an investment decision-making framework. These criteria are drawn from the preliminary results of Isidro’s Agroenterprise Capacity Assessment, which has been utilized to evaluate capital investments, and they overlap nicely with the findings of the literature I reviewed. Two examples are a paper published in AIMS Agriculture and Food which proposes a vertical integration analytical framework.[4] The second is a Mckinsey strategy paper entitled: “When and when not to vertically integrate.”[5]   I am hopeful that the framework will stimulate conversation and feedback amongst key actors in the agri-finance space.

Intro Notes: The questions/filters below should be applied based on the SME’s current state, and concretely in reference to the proposed step-change investment. For instance, if a coffee cooperative is looking to vertically integrate, and begin dry milling or roasting their coffee, the step-up to dry milling or roasting should be evaluated, not an abstract step-up from producing to wholesaling.    
First-level: Answer the initial screening question.

Depending upon whether the answer is a “yes” or a “no”, a different score threshold will need to be reached on the second-level of analysis before proceeding to the third.
Second-level: Score the Agricultural SME on the following 4 metrics, the higher the score, the more sound the decision to vertically integrate (and thus the decision to invest).

A score of 8+ with a first-level “Y” should proceed to step 3. A score of 10+ with a first-level “N” should proceed to step 3.
Third-level: Answer the following 2 management/execution questions before finalizing the investment decision.
Is the market underdeveloped or unreliable? Is integration, to an extent, necessary to access clients?[*]

Yes; must score 8+ on second-level analysis.

No; must score 10+ on second-level analysis.
Does the product have a higher or lower potential for differentiation (certifications, quality, sustainability)?

Highly differentiated (specialty coffee, fine wine, fine flavor cocoa) – 3 points

Moderately differentiated (fair-trade certified bananas, organic cotton) – 2 points

Homogenous (commodity soy, corn, wheat) – 1 point
Does the SME have an adequate management team in place (key roles on the team are filled: Manager, Finance, Ops/Sales) to execute the planned investment?

Yes– proceed to final question.

No– can the company be supported to fill these roles? If so, proceed to the final question. If not, reconsider.
Does the opportunity exist to link consistently with higher-value markets?

Yes, direct-trade, multi-year relationships – 3 points

Direct-trade possible, but highly market-driven, annual contracts – 2 points

Non-direct, year to year – 1 point
Has the SME done basic to adequate planning (annual workplan, financial model, market research) to ensure the success of the investment?

Yes, make a final positive decision.

No. Make a final positive decision if the investor can provide TA to prepare the SME.
Does a lack of market power limit entry or access to buyers?

Yes, greatly, unable to access buyers – 3 points

Somewhat. Harder to compete, capture value – 2 points

Not really, highly competitive market, other providers available to partner with/contract – 1 point
What is the ratio of the proposed capital investment versus the value-added price after integration?

Profitable – 3 points

Slightly positive – 2 points

Even/Negative – 1 point

To date, we have run 11 Isidro investment clients through the framework. So far, the results are promising. The scenarios we have run, and the guidance provided by the framework, align well with the reality of each of these diverse businesses on the ground. The thresholds/divisions between scoring categories could be calibrated and polished to a greater extent, and perhaps other criteria could be added (the product’s degree of perishability?); further debate and additional refinement of the decision-making tool are welcome. Nonetheless, the framework should help investors evaluate vertical integration related financing decisions more holistically, helping to solve another of the unique challenges of investing in agriculture. In turn, this will hopefully lead to more medium term and long-term capital flowing to smallholder agriculture.

[*] There are many instances where rural agribusinesses are pressured to integrate out of necessity, rather than because it is a sound business decision. For instance, if they don’t provide credit to their members, their members won’t deliver the raw material, and other local banks won’t lend to agriculture. The business produces a perishable crop, and there aren’t any other businesses in the rural area where the farmers live that has cold-storage equipment. 

[1] Rubén Medina Serrano, María Reyes González Ramírez, José Luis Gascó Gascó. Should we make or buy? An update and review. European Research on Management and Business Economics, Volume 24, Issue 3, 2018, Pages 137-148.

[2] Pathways to Prosperity. Rural and Agricultural Finance. State of the Sector Report. ISF and Mastercard Foundation. November 2019.

[3] Candemir, A., Duvaleix, S. and Latruffe, L. Agricultural Cooperatives and Farm Sustainability – A Literature Review. Journal of Economic Surveys, 35: 1118-1144. 2021.

[4] Katharina Biely, Susanne von Münchhausen, Steven van Passel. Vertical integration as a strategy to increase value absorption by primary producers: The Belgian sugar beet and the German rapeseed case. AIMS Agriculture and Food, 2022, 7(3): 659-682. doi: 10.3934/agrfood.2022041

[5] Stuckey & White. When and when not to vertically integrate. The McKinsey Quarterly. 1993.