CoBank's Approach Conserves Capital

Two blogs ago I made the following observation: "Boards of directors make one of two decisions when the Board determines the co-op cannot continue to allocate all or nearly all patronage earnings and reasonably expect the co-op to redeem all that equity. One decision is to follow a CoBank approach to equity management. The second, alternate decision is to adopt an approach that creates an appreciable equity interest.

This blog will further address how the CoBank approach conserves capital over the long run.

CoBank's approach conserves approximately $90 million annually (remember, we are working with a specific case study involving the distribution of $100.0 million of cash)of capital by reducing the amount of allocated equity that CoBank must redeem at a later time (except at dissolution). See slide #10 in the powerpoint presentation at  http://www.blackdogcooplaw.com/case-study-managing-allocated-equity-1.  Obviously CoBank's approach conserves lots of capital when we view it over CoBank's entire life ($90 million per year theoretically forever under the $100.0 million case study).

Parenthetically, no one could object to any co-op allocating and distributing every dollar of patronage earnings with QNAs so long as the co-op has sufficient surplus working capital and earnings to redeem that allocated equity when members expect it to be redeemed. Everything depends on the the individual financial and economic metrics of each co-op.

Circling back to the issue of conserving capital, why does conservation of capital matter if any co-op's board of directors has complete discretion over redemptions of equity? That is, CHS's board, for example, has the authority to refuse to redeem that added $90 million of allocated equity - and can defer some or all the decision indefinitely - so what's the big deal if CHS does not have sufficient capital to redeem the $90 million of allocated equity when it otherwise expects to redeem it?

The big deal is that capital is precious. It matters how one sets up member's expectations and how the board positions the Co-op to avoid wasting capital, making up for mistakes or managing unforeseen and unexpected financial weakness.

Capital is more precious for co-ops with large capital requirements (for PPE, term debt repayment and working capital, for example) than investor owned business organizations, who have less leverage and more cash flow than co-ops (ordinarily one hopes and expects to see a positive rather than negative correlation between debt and cash flow). Access to Capital and Firm-Level Investment Behavior in Food Industries: A Comparison; Cooperatives and Publicly Traded Firms,(page 17 and 18)Chaddad and Heckelei, Washington State University, 2003.

Co-ops in CoBank's position can recover more quickly and are under less pressure to succumb to paying too much (or too little, but the bigger danger to a co-op is paying too much cash and of raising expectations for continued distributions in the future) cash and weakening their liquidity position than are co-ops in CHS's position. If CoBank makes a mistake or its financial performance unexpectedly falters - if, for example, CoBank paid too much cash in 2009 - it can reverse that relatively easily in 2010 or 2011 or 2012 by distributing less cash. In the meantime, CoBank's stronger value proposition will carry it over a one (or two, or three year) year bump if CoBank has to distribute less cash to correct the mistake.

Co-ops in CHS's position are in a more difficult position and less able to recover as quickly because those annual distributions of $90 million of added patronage earnings with QNAs are constantly facing down the board of directors. These co-ops pay a 20% to 35% cash refund, all or most of which eventually ends up in the government's hands when the producer pays income and self-employment taxes on those distributions of patronage refunds. Consequently, the real financial benefit for members is realized when their allocated equity is redeemed.

It's not easy to face down members who understandably want and expect their allocated equity to be redeemed. The 35% cash patronage refund is almost an aside because it did not stay in anyone's pockets outside of the government, which is why the value proposition of these co-ops is not as strong as co-ops in CoBank's position. A weak value proposition does not carry co-ops in CHS's position over bumps as well as co-ops in CoBank's position who have stronger value propositions, and hence the demand to redeem allocated equity on co-ops in CHS's position is understandably far more insistent. Therefore, co-ops in CHS's position are pushed further by members - understandably so - and the boards of directors more chronically susceptible to distributing too much cash.

My own experience as a loan officer at the St. Paul Bank for Cooperatives supports this conclusion. It is comparatively easy to manage equity redemptions at a co-op that is under extreme financial stress. The answer to almost any request for redemption is nearly always "no" for co-ops under extreme stress. Far more heartache is experienced with co-ops that are making money. The desire is always to lean as far forward as one can to redeem as much allocated equity as possible. No board wants to redeem anything less than the maximum amount possible. Where that line is - where the maximum is - is never easy to figure out because it is always possible to redeem a bit more.

Co-ops using a CoBank approach to equity management enjoy a more narrow focus on redemptions of equity. It easier to manage cash flow over a one to three or five window of time than co-ops using a CHS approach where the window of time over which to manage cash flow is arguably always twenty five to fifty years long. The CHS approach can create more pressure over the long pull to redeem equity and push cash flow restraints as far as possible toward distribution of more rather than less cash.

In fact, the pressure to redeem allocated equity for Co-ops that follow an approach like CHS's may, in a circular fashion, contribute to the added leverage that Chaddad and Heckelei write about in their article noted above.