Streetwise Professor

April 20, 2015

Cargill: Still Private After All These Years to Solve Agency Problems, or Because of Them?

Filed under: Commodities,Derivatives,Economics,History — The Professor @ 8:29 pm

The commodity trading sector is remarkable for the prevalence of private ownership, even among the largest firms. My recent white paper discusses this issue in some detail. In a nutshell, publicly-held equity is a risk sharing mechanism. The ability of commodity traders to share some of their largest risks-notably, commodity flat price risks-through the derivatives markets reduces the need to rely on public equity. Moreover, private ownership can mitigate agency problems between equity owners and managers: the equity owners are often the managers. As a consequence, private ownership is more viable in the commodity trading sector.

The biggest cost of this ownership structure is that it constrains the ability to fund large investments in fixed assets. Thus, private ownership can impede a firm’s ability to pursue asset heavy strategies. As I note in this white paper, and my earlier one, commodity firms have used various means to loosen this constraint, including perpetual debt, and spinoffs of equity from asset-heavy subsidiaries.

Another cost is that owners tend to be poorly diversified. But to the extent that the benefits of high powered incentives exceed this cost, private ownership remains viable.

Cargill is the oldest, and one of the largest, of the major privately held commodity traders. (Whether it is biggest depends on whether you want to consider Koch a commodity trader.) It is now commemorating its 150th anniversary: its history began as the American Civil War ended. Greg Meyer and Neil Hume have a nice piece in the FT that discusses some of Cargill’s challenges. Foremost among these is funding its ambitious plans in Indonesia and Brazil.

The article also details the tensions between Cargill management, and the members of the Cargill and McMillan families who still own 90 percent of the firm.

The last family member to serve as chief executive retired in 1995, and now only one family member works full time there. This raises questions about how long the company will remain private, despite management’s stated determination to keep it that way. The families are already chafing due to their inability to diversify. Further, at Cargill private ownership no longer serves to align the incentives of owners and managers, in contrast to firms like Trafigura, Vitol, and Gunvor: even though Cargill is private, the owners aren’t the managers. Thus, the negatives of private ownership are becoming more prominent, and the benefits are diminishing. There is separation of ownership and control, with its associated incentive problems, but there is no compensating benefit of diversification.

Indeed, it is arguable that the company remains private because of agency problems. Current management, which does not own a large fraction of the firm, is not incentivized to de-privatize: there would be no big payday for them from going public, because they own little equity, and they would give up the perquisites attendant to controlling a vast corporation. Moreover, as long as the families can be kept happy, management doesn’t have to worry about capital market discipline or nosy analysts. Thus, management may be well entrenched in the current private structure, and the number of family owners (about 100) could make it difficult to form a coalition that would force the company to go public, or to craft a package that would make it worth management’s while to pursue that option.

In sum, Cargill is a marvelous company, and has been amazingly successful over the years. Its longevity as a private company is remarkable. But there are grounds to wonder whether that structure is still efficient, or whether it persists because it benefits management.

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  1. Cargill or Koch industries are better able to trade and manage risk and create long-term value by the economic means because they always maintain a strong financial health to absorb shocks internally. It is my idea to explain why these companies will be in the business for a long time.

    S&P rating:
    Cargill: (S&P: A)
    Flint Hills Resources, LLC (S&P: AA-)
    Koch Resources, LLC (S&P: AA-)

    Some public traders
    Noble Group (S&P: BBB-)
    Glencore (S&P:BBB)

    On special case:
    Trafigura, the private company doesn’t desire to be rated by credit rating, maybe because it would be too ugly to put on their website, rating is not even mentioned in their 2014 report. However, Trafigura Securitisation Finance PLC packages structured products (often backed by receivables and with credit enhancements from Banks) to be offered privately to hedge funds appealed by HY.
    Rating on tranches can be anything from AAA to BB (Junk).


    Comment by simon jacques — April 21, 2015 @ 4:20 am

  2. SWP, no argument that the agency problem is reduced when the owners are managers, but I am not convinced that risk capital is cheaper for private commodity firms than public ones. There are many large private companies outside the commodity sector, such as IKEA- and they access risk capital at similar rates to public cousins. The ratio of private/public firms in europe is much higher than in the USA. This reflects historical inertia rather than marginal economic incentives. Ditto for commodity firms.

    Comment by Scott — April 21, 2015 @ 9:56 am

  3. @Scott-I don’t believe risk capital is cheaper for private firms. The reverse: the capital is expensive, but the higher capital cost is more than offset by the effects of improved incentives. My skepticism about Cargill stems from the observation that it now seems to have the worst of both worlds, more expensive risk capital, with no real improvement in incentives because ownership and control are separate.

    I don’t know enough about private corporations in Europe to say anything meaningful. It would be interesting to examine capital costs for private and public firms, after controlling for various factors, including balance sheet structure (in particular, the amount of equity and debt/equity ratios). The nature of capital markets (both equity and debt) should matter too. Costlier capital markets can lead to a reliance on bank finance, and private firms likely operate at less of a disadvantage in securing bank finance.

    I agree there can be hysterisis/path dependence, but that is not inconsistent with an agency problem. Indeed, hysterisis suggests some transactions costs that self-interested managers can exploit. Hysterisis also likely depends on the tax environment. There can be a big tax hit from going public.

    The ProfessorComment by The Professor — April 21, 2015 @ 12:49 pm

  4. @simon-Maintaining buffers to absorb shocks internally is expensive. My points are (a) the ability to manage important risks (e.g., flat price risks) through derivatives markets reduces the amount of buffer required to a level sufficient to absorb operational, quantity, and basis risks, and (b) improved incentives from alignment of the interests of managers and owners can be sufficiently beneficial to offset higher risk capital costs. As I said in my response to @Scott, hysterisis is relevant, but just citing it begs important questions. In particular, why maintain private ownership when incentive benefits are not apparent, but the constraints and costs of risk capital are?

    Regarding Trafigura, the credit rating issue is a red herring. They have to borrow consistently, and the rates at which they borrow are disclosed. That’s much more informative than any credit rating. They just issued a public bond (listed on the Irish Stock Exchange). 500mm Euros for 5 years at 5 percent. The credit spread tells the tale far better than those at S&P or Moodys can. And I can tell you, based on discussions with them, that S&P has a rather shaky understanding of the risks of commodity firms.

    The ProfessorComment by The Professor — April 21, 2015 @ 1:00 pm

  5. P.S The 500mm Euros Bond for 5 years @ 5 percent, is UNSECURED debt, not secured by any specified assets as collateral. It’s speculative, high-yield, so investors in these bonds will also look at the CDS market to insure it. Trafigura Credit Default Swap insurance premium is traded every day, very informative it seems…

    “S&P has a rather shaky understanding of the risks of commodity firms.”

    That’s what the industry is now touting but don’t tempt the tantrum.
    Credit rating will always be less appealing than putting 7 Million barrels per year on a website for the self-indulgence, vanity and the enhancement a trader.

    S&P based their outlooks on Credit, not Performance like Trafigura mostly to fund its daily requirements with these “structured products”. It is implied that S&P’s outlook for Trafigura would too bad because of:
    -weak cash positions
    -combined with the high concentration of short-term debt
    -in a systematically risky volatile commodity industry.

    For the point about “Maintaining buffers to absorb shocks internally is expensive”:

    I would say this to smart people reading, deal with the debt problem by creating less debt, not taking more.

    In the real life test of the businessworld (If I can take the personal example of my own father, businessman in a terrible industry where most of people who followed B.Schools professors advices on the huge benefit of Debt,(WACC theory)… One after another have all failed “the real exam of the businessworld”, closed the shop. But for those and who managed to stay alive, there is a Huge Upside potential ; they can finally take-over the market shares and margins.

    I just happen to think that Koch and Cargill are in the same position in their respective industry, waiting for others to fail and buy trading book @30 cents on the dollar because of what I said earlier in my other comment.
    Patience pays, both the Upside and the margins will be terrific.

    Simon J

    Comment by simon jacques — April 23, 2015 @ 11:28 pm

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