The Distinction Between Endogenous and Exogenous

Time to elaborate on the distinction between endogenous and exogenous equity management approaches. We've been circling around these distinctions in this blog; just as well bring them to the forefront. Think of endogenous as "it is what it is". Think of exogenous as "we will make it what we want it to be". For equity management issues, endogenous is passive while exogenous is aggressive in its approach.

Had an extended exchange of e-mails with Professor Barton a few years ago. Professor Barton consistently asserted that equity redemptions must be and are endogenous. Prof. Barton meant that all patronage earnings should be allocated with QNAs, and that redemptions should be determined exclusively by the Co-op's excess cash flow. Barton believes so strongly in the endogenous approach to equity redemptions that he accused me of trying to make water run uphill when I asserted that the Co-op should also manage the size of their allocated equity obligation as well by paying some income tax.

Professor Barton appears to believe that not only does any (regardless of the Co-op's capital requirements) Co-op's DNA allow for the redemption of allocated equity in a reasonable time, but the Co-op's DNA affirmatively enables the Co-op to redeem the allocated equity on time (lets say long before the member's death) provided the Co-op is managed in an efficient manner. Professor Barton's philosophy toward equity management is endogenous.  "It is what it is", and if the Co-op is not redeeming allocated equity by the time of the member's death - at the outside - the Co-op is either not efficient or it is going through a building project and it will catch up redemptions as soon as the Co-op pays down the debt.

CHS's approach to equity management is endogenous. CHS does not manage the size of its allocated equity obligation because it allocates all patronage earnings with QNAs and pays no income tax on any of its patronage earnings. CHS manages the size of its allocated equity obligation solely by redeeming its allocated equity as and when it can from excess cash flow. Barton would agree with this approach.

A few years ago in fact, Barton asserted that CHS was speeding up its turn over of equity. Hence, its redemption situation was improving and the endogenous approach vindicated. Professor Barton is correct if you measure progress looking backward. I do not believe CHS has ever been in a stronger position with its turnover of allocated equity. CHS is paid up through earnings and allocated equity that were distributed as recently as 1995 - only fifteen years ago (approximately). I'd bet a hundred dollars that is as good as it will get for CHS.

My opinion is - looking forward rather than backward - that CHS's equity management situation has never been in a more difficult position. I do not believe that CHS's allocated equity has ever been higher than it is now: $2.3 billion of allocated equity, which is more than double the amount of its allocated equity just six years ago. So looking forward from here, it is not clear to me that CHS's position has improved, and we don't know what the future holds for an obligation that large.

In fact, I'd bet that $2.3 billion of allocated equity will look larger and larger in CHS's rear view mirror. We can expect that member insistence - completely understandable and expected - to redeem that allocated equity will be the cause of irritation and distraction to the Board of Directors over the next twenty five years or more as capital for redemptions competes with capital that is needed for PPE and/or building CHS's solvency and/or liquidity.

CoBank's approach is exogenous because it manages the size of its allocated obligation by not allocating all of its patronage earnings with QNAs. Rather, CoBank pays some income tax and allocates some of its patronage earnings with NQNAs that will never be redeemed . . . unless and until CoBank dissolves. One reason I asserted a few blogs ago that exogenous approaches like CoBank's appeared to blow by agricultural economists is that they doggedly hold on to an endogenous approach in the face of evidence to the contrary. Why would Barton and others seem to be almost oblivious to CoBank's equity management approach?

CoBank's allocated equity increased by only 25% during the time that CHS's allocated equity was more than doubling. This is what an exogenous approach looks like. Not only does the Co-op strive to be efficient, profitable and to carefully manage PPE expenditures so that its budget for redemptions of allocated equity is as large as possible, but the Co-op also manages the size of the allocated obligation itself by paying income tax on a portion of patronage earnings rather than allocating everything with QNAs.

You can expect Professor Barton and other colleagues of his to make arguments about equilibrium, but its not clear what equilibrium means as an argument against CoBank's exogenous approach. It appears pretty conclusive that CoBank's approach creates a stronger value proposition by distributing more net, net cash more quickly,and it creates a stronger capital structure by reducing the size of the allocated equity obligation. CoBank's approach also reduces the pressure on boards of directors to redeem equity when doing so could be a failure to discharge their fiduciary obligations. All that seems hard to dispute.