Note: Earlier this year, Root Capital published our inaugural issue brief, on the emerging business case for financial institutions to conduct due diligence on the social and environmental practices of their borrowers and investees.
This is the third in a series that goes deeper on that social and environmental due diligence, addressing questions such as: What do we look for in the business we lend to, and why? How do we go about it? And how do small-scale producers and agricultural businesses in Africa and Latin America benefit, as well as upstream exporters, processors, retailers, and consumers worldwide?
In our previous post, we described the mutually beneficial relationship between agricultural businesses, smallholder farmers, and the natural environment that is at the heart of what we look for in our social and environmental due diligence. We concluded by noting the critical role that trust and credit play in facilitating this mutually beneficial cycle. In today’s post, we go deeper on each.
The Role of ‘Compromiso’ (Trust)
In Latin America, the business managers and farmers we work with often talk about the strength of the ‘compromiso’ (commitment, or trust) between them. Trust is both a result and a cause of the mutually beneficial cycle between agricultural businesses that invest in smallholders, and smallholders that deliver their crop to the business through good harvests and bad. Trust becomes a self-fulfilling prophecy.
To elaborate, farmers often have a choice of buyers of their crop, including one or more agricultural businesses and a variety of local middlemen and traders, some of whom may use exploitative practices (for instance, weighing farmers’ harvests on scales that have been rigged to under-estimate the weight). Before each season, farmers typically agree with an enterprise on roughly how much volume they will deliver to that enterprise, and the enterprise seeks contracts with its own buyers based on these volume estimates.
Farmers whose livelihoods are improved by the enterprise, and who trust the enterprise to balance its interests with farmers’ interests over the short- and long-term, will fulfill their pledged volume to that enterprise to the best of their ability. They thus enable the enterprise to successfully fulfill its own export contracts. With cash from these sales, the enterprise can afford to pay higher and earlier payments to farmers and to help them to invest in their own productivity, driving a mutually beneficial cycle that in turn supports the business’ ability to repay creditors.
Conversely, when farmers do not trust the enterprise to pay them a higher, timely price, they are more likely to ‘side-sell’ the harvest they promised to the enterprise to local middlemen, who may offer cash upfront. This potentially causes the enterprise to default on sales contracts with its own buyers. As a consequence, the enterprise, lacking cash inflow from sales, fails to make adequate or timely payments to farmers. In turn, farmers become even more likely to side-sell in the future, and a vicious cycle ensues that jeopardizes the welfare of both, as well as the capital of the enterprise’s creditors.
Client Case Study: COOMPROCOM
A farmer affiliated with our client COOMPROCOM, a coffee cooperative in Nicaragua, sums it up well: “It bothers COOMPROCOM when members sell to the (local) market [instead of to COOMPROCOM]. It´s like they are just waiting for the benefits from the cooperative without actually contributing. We should help the cooperative so that it can help us.” In the most recent season, COOMPROCOM paid premiums to farmers of 5-10% over the local market price. Of equal or greater importance to farmers are the small loans that COOMPROCOM makes available for emergencies or to get through ‘los meses flacos’, or the lean months between seasons. In return, COOMPROCOM’s farmers delivered 90% of their pledged coffee to COOMPROCOM, enabling it to increase its sales volumes by 33% over the previous year. (A full impact case study on COOMPROCOM is available at info.rootcapital.org/coomprocom.)
The Role of Credit
Credit has a critical role to play in the virtuous cycle. If the business lacks cash on hand to purchase farmers’ crops at the time of harvest, forcing farmers to side-sell, or if the business cannot access a long-term loan to invest in processing equipment, the cycle between business and producer breaks down. In turn, this may cause farmers to adopt short-term, environmentally damaging survival tactics. Loans from Root Capital and other financiers play this role in lubricating agricultural value chains that deliver benefits to smallholders and the environment.
Social due diligence can help financiers to look for indicators of a mutually beneficial cycle between the farmers and the business that will drive a successful upcoming harvest season and prove resilient to market shocks (download the social and environmental scorecards used by our loan officers here). Credit will have greatest impact where this virtuous circle is in place. Financiers with a longer-term view can also use environmental due diligence to evaluate whether the practices of farmers and the business are conserving or degrading the local ecosystem, which is necessary to support successful production – and rural livelihoods – through future harvests.
Check out the other posts in this series: