July 2023
Proterra originated in the food and agricultural space under Cargill. After splitting from Cargill, they partnered with Farm Credit, an independent federal agency, to create a unitranche lending solution for food businesses that may not have access to traditional bank loans. Farm Credit is not a deposit-based bank; they fund themselves through the issuance of bonds. Rich says Farm Credit is a mission-oriented, member-owned cooperative providing a wide range of financial services to support agriculture, including loans for land purchases, operating expenses, equipment financing, etc.
Proterra helps Farm Credit reach branded food companies that have pricing power and control over their gross margins, providing reliable cash flow streams and defensive qualities- even during challenging times like the pandemic. Proterra does not lend to farmers because the market decides the prices of commodities, which can be volatile and unpredictable. Therefore, Rich says even though their investors may take on more illiquidity, they can generally expect more return and minimized risk.
Proterra's focus on food lending offers a specialized and niche investment opportunity in the broader financial landscape while emphasizing responsible investing, considering environmental, social, and governance (ESG) factors.
Click here to subscribe to our YouTube channel.
Hello, everybody, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski, joined by investment manager from Proterra Rich Gammill. Rich. Thanks for joining us.
Thanks for having me.
So we talk a lot here at Morton about, you know, our core tenets for how we invest, which have to do with risk management, true diversification and cash flow. And Proterra, which focuses on food lending checks, all of those boxes. It is definitely different. Or, you know, interest rates or economic volatility is going to affect food. The food space much different than maybe traditional assets.
It's definitely an income focused investment solution. And it's very diversified amongst everything else. So I'm excited to talk to you today. But if you could start with sort of a little bit about Proterra and then like what is food lending? Because initially when you think about it, it's like they lending to farmers to grow corn. What does that look like?
Well, I think it's probably starts with who Proterra is, right? So kind of how we got started. Our roots go back to when we were first part of Cargill, and a lot of people don't know who Cargill is because it's not a public company. Family owned business has been around for like 150 years. So it's a dominant player in the food ag space that does logistics and origination of grains and all sorts of stuff globally.
Right? So we were inside an asset management division of Cargill, and so we naturally started building private equity or private investment strategies there first and focused on the food ag. So we've always been food ag, like it wasn't just something we caught wind of or jumped on recently.
You've always been part of businesses that are in the food and agriculture space.
So we've always been that. But we were new to credit when we spun out from Black River at the end of 2015 to form Proterra. We did not have a credit strategy, right? We were only private equity and we also invested in farmland. So we started, but we didn't have a strategy in the United States. Cargill didn't want us investing in their backyard as a US corporate.
They said, Now do other things. Don't play in the United States. So when we spun out, the United States was kind of open to us and we started thinking about how we would be relevant again, staying in the food ag value chain, but what would be the right strategy? And that really initially our bias was to think about doing equity, right?
Do private equity, but in the food value chain in the United States, returns equity, in my opinion, can be kind of like high teens at best. And then we started thinking about it from a credit standpoint. Private credit was obviously an emerging category in asset management. This is back in 2016. And I met one of our team members, Jonathan Logan, who at the time was a senior executive at Farm Credit.
And Farm Credit is this government sponsored entity, a GSE that's like Fannie Mae. You know what Fannie is to the mortgage market, Farm Credit is for the food ag space. Been around for over 100 years to provide first lien lending, but they can't do kind of what the M&A market needs, which is to provide 4-4.5 terms of leverage to complete a transaction.
And so we decided to partner with them and created a product, a unitranche lending solution to serve the needs of that market. And so it really does fit the bill of what you're saying, because when we designed it from the start, we were saying, hey, look, there's an underserved market here. We're not trying to do something structurally creative, no special situations or high leverage.
And we weren't doing anything really that unique in terms of you look at the core product, it's just a regular first lien loan, five year term to a good quality food company. But what we're doing that's special behind the scenes is that we do a unitranche loan and we chop it into an A and B tranche and we sell the A tranche to Farm Credit.
We keep the B tranche, and that gives us some opportunities to kind of pick up some extra yield. But at the core product, it's just cash pay interest loan, right? No pick, no back end warrants or kind of creative stuff like that. It's just a regular first lien term loan, but that generates a pretty interesting cash yield. And so when we designed it from the beginning, we weren't looking to do anything kind of crazy on the risk spectrum.
It's really more addressing an underserved need in the food space with the dominant lender in the market. Farm Credit is over 400 billion in assets. They're huge, but they couldn't really serve the market, especially when you think about like a private equity firm buying a CPG company. They only can do about two and a half to three turns in them.
The buyer wants more like four turns of leverage, so we need to help them grow. They just need a slightly larger loan to finance a transaction. So we stepped into that void. Got it. Kind of filled the gap with Farm Credit as our partner. And that's not too different than somebody going to Fannie Mae or Freddie Mac. And they get a jumbo loan, right? The conforming part may be sold off.
That is a perfect analogy in the mortgage market, if you can get a conforming loan that Fannie Mae can buy as a GSE, that's a lower rate, right? When you see remortgage quotes, jumbos are always 25, 50 basis points more, why? Because they can't sell that loan to Fannie Mae. Sure, the banks are going to have to hold that on their balance sheet, and that's the analog here.
If we can structure a transaction where that first part of the loan, the top part fits the Farm Credit kind of conforming loan box, and we can sell that to them. We can sell it to them at a pretty attractive price, thereby levering the loan, complete loan solution, and we keep the rest of it, we’re the arranger, organizer.
We pick up kind of an advantaged return or spread what you would generally refer to as alpha, right in terms of financial risk manual, you have the beta return, which is just kind of the market return. We're picking up an additional, I think kind of 3 to 400 basis points of alpha because of we're able to fit that and feed that Farm Credit demand at a pretty low price.
Got it. Before we get into some of the types of companies that you're helping for these loans, because we just recently had a banking crisis and Silicon Valley Bank. You and I were having a conversation about there are some structural issues with banks in terms of taking in deposits and having to loan that out. And some of them got in trouble with, you know, lending long and borrowing short.
But, Farm Credit is structurally different and they're not associated with the same types of risks as some of these smaller, more regionalized banks. So even though a lot of people might not have heard about Farm Credit, why don't you tell us a little bit about how they're different?
Yeah, I think first and foremost, Farm Credit is not a deposit based bank, right? So they don't rely on deposits from people like you and I to get their balance sheet capital to lend out. Right. They fund themselves through issuance of bonds that trade like the ten year Treasury because it's a government linked entity. They issue bonds that are like the ten year plus ten basis points right, so they issue paper, that raises money for the system and then the banks, they have a funding bank that pushes that money down into the lending institutions that make up Farm Credit. And each there's 65 Farm Credit associations around the country. Back when it first got started, every county in the country had its own Farm Credit. No kidding. This is over 100 years ago.
Yeah, they have since merged, merged, merged to connect, consolidate. So now it's like super regional Farm Credit associations. But the structure is actually a cooperative. Each individual Farm Credit bank is owned by the borrowers. It's a nonprofit. This is like a credit union, right? So the members own the bank and the bank is a nonprofit institution. Its objective is to it's a mission oriented lender to provide capital to rural America.
And it's done an amazing job of it. And we basically just opened the door for them to provide capital to a different type of borrower than they could before. But their main customer is frankly, a farmer. Okay, provide a lot of loans to just rural farmers, but they went across the whole value chain from farm, you know, dirt farmers all the way to grocery stores.
Got it. And so if that's their kind of core client base, and you partner with them, what are some of the types of companies that you are providing loans to?
So we can really if you look at the mandate of the farm, we can really participate kind of wherever Farm Credit can, I guess you would say. But really our sweet spot is to lend to branded food companies and there's a reason for that. And there's also a specific area that we will not lend to very specifically, which is we will not lend to production agriculture.
We are not lending to farmers. Yeah, well, maybe we start with that. The reason we don't want to lend to a farmer is if the product you produce is a commodity and it's priced by the Chicago Board of Trade, you don't have any pricing power, right? You're a price taker. If you kind of go back to Econ 101, the price setter, price taker concept, like they don't get to decide the price of their corn, the market prices the corn as a lender that's very unpredictable and volatile.
Right. So you can do a mortgage against the dirt and asset loan, but we're not asset lenders, we're cash lenders, We're lending against profitability or EBITA. So we aren't going to do that. Too risky. So kind of back to your open question of like the risk tolerance or how we think about risk, We really are not looking to take risk, but we're looking to be well covered in terms of collateral.
But also in a reliable cash flow stream. So if you flip side instead of production, if you look at branded food, they have a brand, right? They have pricing power. They can tell Kroger, Whole Foods, Costco, how they're going to price their product. And if there's inflation on the inputs, they can raise the price no different than you go to the grocery store and suddenly Cheerios are a dollar more.
It's because General Mills decided that Cheerios were a dollar more. Right. And so that's important for us that every company we lend to, that they have pricing power so that they can control their gross margins. And that played out really, really well during COVID. When we saw input prices skyrocket, our portfolio companies were able to react to that not immediately.
And they got margin compression because the inputs went up right away. Takes a little while to raise the price of the product. Yeah, and that creates resilience and defensive kind of makes a more defensive portfolio. Sure.
And that was an interesting time for you because it was almost you living out like your worst fear when it comes to this. Yeah, totally complete global shutdown. How's it going to affect these food companies? And then you've got inflation, rising prices. But, you know, the the these companies were fairly resilient through it for a number of reasons.
They have been I think, you know, it's because they could reset their pricing. You know, we did have some of them we covenant all of our loans. So if you look at the product like what is it actually that we are selling or what is the product of our credit fund? It's a first lien term loan to a borrower up to about four times of EBITA, and it has cash pay, interest.
They got to pay interest every quarter. No kind of back ending, in the industry, you call it pick a payment in time. We don't do that. It's all current cash paid just like you would on a regular loan on your house or something else with amortization also. But and more importantly is we have covenants and a covenant is something that says, okay, if you go beyond this kind of leverage level or something changes in your earnings, you might trip a covenant.
And that gives us an opportunity to go back to the borrower and have a conversation, essentially reprice risk. We may have to charge you more interest or we need to see more cash coming in from the private equity firm that owns the company to kind of cure the default or cure the covenant trip, it's not really a default.
It's more just kind of a warning sign, saying, Hey, things are a little off here. We need to fix this. We have had plenty of those over the course of COVID, right? And where the owners of the CPG company needed to step in with more cash, for instance.
But that's again, part of the defensive nature of what we're doing in private credit versus if you were to buy, say, like a publicly listed high yield bond, you know, they don't have covenants. All right. You know, so you don't have that opportunity to reprice risk and to kind of reset and that we do. And I think that's really helpful and how we've kind of lived through the cycle for sure.
And that is such a great point in terms of the difference between doing loans in the private market versus, you know, traditional bonds or high yield bonds in the public market. I mean, you are in constant conversations with your borrowers. You're understanding where they're at from a health and a growth standpoint. They have certain metrics that you want to see them grow at, and then you're you're speaking to the people that are fund helping fund these companies and say, hey, listen, we need you to put more cash in here to make this better.
So there's a lot more things at play or conversations that you're having than maybe what what clients are exposed to outside of that.
Absolutely. And I think the trade off is it's less liquid, right? So when you invest with us, you're going to put your money with us for a period of time. There's a lockup or it's closed end fund. So you're trading kind of illiquidity for higher yield or higher return because of the things that we're able to do versus buying a high yield bond, which, you know, it's it's a liquid instrument.
You can sell it, it's traded, but you get lower return and much less of these kind of risk management type features. So that trade off, I think is something you always have to look at. But in our opinion and I think it's played out, is that our brand of lending, you know, through a private credit model into a sector that we're experts in with a really, really attractive GSE partner, we're able to generate real alpha.
I would say the beta is that high yield return that you get from a high yield bond, we’re that plus, you know, about 400 basis points. So it's worth taking some liquidity. And especially I think in this market, we're just seeing really interesting opportunities, it's a unique time in private credit when you have the Fed funds rate as high as it is and where all of our loans are floating rate.
So we ride with that. You know, the tide as it rises, right?
Rates go up.
They go up with rates. So we're putting a spread on top of an index. Used to be liveware now it's called SFOR as well. SFOR Yeah. So we're indexed to that. So, you know, SFOR is now 5.25 around there and our kind of average yield on our whole loan is six and a half, 650 basis points over for actually a piece that we keep after we've sold the Farm Credit, it's close to a thousand over. So, you know, we're now running it like a nominal interest rate on a new loan of closer to 15%.
And so it's almost an investment that's going to generate really nice cash flow. But if interest rates continue to rise, you're going to see an increase in that cash flow down the road, which can help sort of combat that inflation that we've all been feeling. So it's a hedge to hedge against an inflationary environment. Now people ask the question of, well, but can the borrowers afford it? Right? It's getting more and more expensive to borrow money. Isn't there kind of a limit? Indeed there is. And that's what we measure it using something called a discounted or debt service coverage ratio. DSCR is basically saying compare the earnings of the company to their interest expense.
Do they have enough earnings to cover this amount of debt? And indeed, if you look at our loan book over the last couple of years, the new loans we’re writing. We're not issuing five times EBITDA loans anymore. We're more at like four times because of that factor. It's more expensive to borrow. And so they can't borrow as much.
Right. And another key measure we use is something called the equity cushion. When when a private equity firm is buying a company, say they're buying it for eight times EBITDA. Right. We want to make sure that of that purchase price, at least half of the purchase price is coming from them in cash. Right. And we call that the equity cushion.
Yeah. So you want half the deal at least to be from their cash and then half our cash, Right. Because you want to make sure there's a lot of skin in the game. If something goes wrong, they don't really want to walk away from that amount of cash. So you got to make sure that we're there's good alignment.
It's another element of private credit, right, where we can sit there with the buyer, the private equity firm, and structure a bespoke kind of solution, but make sure that we're well aligned with that buyer, that if things go wrong, that they're ready to put more money in. And that's indeed played out.
Well. Rich, thank you so much for highlighting, you know, some of the key factors of what Proterra is trying to do, the expertise that you guys have and how you're trying to help protect our clients, you know, going forward in the space and, you know, we look forward to this great partnership.
Thank you. It's been great getting to know you guys. And yeah, I think it's a really interesting time in the private credit space. It's a great time for us and and hopefully it'll play out for your clients as well, because I think our second fund is going to be a good one. Yep. Perfect.
Disclosure:
Information presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. Target returns or other forecasts contained herein are based upon subjective estimates and should not be construed as providing any assurance as to the results that may be realized in the future from investments. Many factors affect performance including changes in market conditions and interest rates and changes in response to other economic, political, or financial developments. Past results are no guarantee of future results. All investments involve risk, including the loss of principal. You should consult with your financial, legal, and tax professionals before implementing any transactions and/or strategies concerning your finances.
