Five years of the IDH Farmfit Fund: Five key trends from our journey so far

 Although there is potential to expand impact, the SME’s growth is constrained by high interest rates and limited financing options, preventing the SME to pay farmers at farm-gate and its ability to scale farmer support. Financial institutions, prioritising opportunities with better risk-adjusted returns, have largely overlooked smallholder agriculture, leaving farmers and SMEs without the necessary capital to unlock their potential.

This made-up scenario reflects a common issue of how the financial system fails to meet the needs of smallholder agricultural market. IDH together with several key partners, established the IDH Farmfit Fund (the Fund) in order to help bridge the financing gap by derisking investments, mobilising capital and demonstrating that viable investments can be made in smallholder agriculture that improve the livelihoods of these farmers.

The IDH Farmfit Fund had its first closing in November 2019. So where do we stand against our long-term goal of ‘making smallholder finance an asset class’? There’s definitely a long way for the sector to go. However, we are proud to highlight that along the bumpy road to where we are now, we’re increasingly seeing the fruits of labour, including:

• 15 investments contracted with 13 investee companies (incl. two follow-on investments)
• €31.5m in investments made, with a further €20.5m in contracting
• Over €100m in co- investment mobilised from co-investors
• Investees expect to reach 4 million farmers through services, credit and off-take (the three investments in contracting expect to reach another 1.6 million farmers)

So, what have we learned over these five years? We are currently working on a publication where we dive deep into our insights and experiences, but as we start the year, we already want to share with you five key trends from our journey so far.

1) Our target segment is complex, and it’s been a learning curve 

The real and perceived risks inherent in smallholder agriculture are high. It varies across sectors but there are significant risks around production, market informality, climate change vulnerability, currency risk, institutional strength, and political stability. Ultimately, the opportunity cost of investing in smallholder agriculture is high and there are many sectors where investors can find better risk-adjusted returns, leading to significant underfunding of smallholder agriculture. However, we are convinced that there are investable opportunities. The challenge is identifying these opportunities and structuring deals in ways that align with our impact ambitions, the companies, co-investors and ourselves.

The first few years  presented additional challenges, such as the COVID-19 pandemic, which shocked operating models and restricted our ability to conduct due diligence. The subsequent period of high inflation, rising interest rates, and the war by Russia on Ukraine further complicated the investment landscape. The impact this had on energy, fertiliser and food prices (and in some cases, availability) disrupted many business models. Additionally, the increasing frequency and severity of climate shocks has intensified production risks and affected entire value chains.

Despite these challenges and a slow start, we are now seeing strong momentum as we mark five years. In the final month of 2024, we contracted two more investments, bringing our total of 15 transactions worth €31.5m.

Three key insights

1. The unique set up of the Fund required testing untested assumptions. The Fund invests with a long-term time horizon and has a strong focus on mobilising other investors. This means we often take the lead in transactions and need to bring co-investors along with us. At the same time, target investees who often have close proximity to smallholder farmers, have typically complex business models, limited data availability, and little experience in obtaining formal investment. In combination, this can make navigating the entire investment process challenging, often resulting in complex transactions, prolonged due diligence and long lead times. We’ve learned through this process, and the experience that we’ve built over this period has been invaluable.
2. Pre-Investment Technical Assistance is widely needed across the sector but is insufficient. Research shows that high risk perception inhibits the use of more pre-investment TA by impact investors who rather use their TA to support the needs of portfolio companies. There are a wide range of TA programs in the sector, but many do not have a sufficiently strong focus on investment readiness. Without more robust and investment-oriented TA facilities, the pipeline for investments across the sector will remain limited. Ultimately, without further investment readiness TA, it will be difficult to close the agri-finance gap.
3. Negotiating with co-investors can be a challenge for a range of reasons (to be explored in an upcoming publication). Therefore, the Fund actively aims to build relationships with co-investors we expect to grow with. For instance, there are now several co-investors who have joined us on more than one transaction. Taking this a step further, we recently agreed a strategic partnership with Oikocredit. This progressively makes future investments more straightforward, where familiarity with each other’s processes and approaches can generate efficiencies.

2) We’ve been able to mobilise part, but not all the financial sector 

Closing the smallholder finance gap requires active engagement with the financial sector. This ranges from institutional investors, development finance institutions and impact investors on the one hand, to local banks, FinTech’s and microfinance institutions on the other hand. We’ve focused on mobilising the first three groups as our co-investors, while making investments in the latter three. When it comes to mobilising co-investors, we’ve seen promising success with fellow impact investors and some DFIs. However, there has been little traction with institutional investors.

One of our three impact archetypes is reaching smallholder farmers through financial institutions. We also invest in more traditional agribusinesses that have direct off-take relationships with smallholder farmers, as well as other innovation-driven business models operating in the smallholder agriculture ecosystem. Currently, investments via the financial sector make up more than half of our contracted investments. However, it is important to note that all these  investments have gone through FinTech’s or local Microfinance Institutions (MFIs). Despite many discussions with local banks (in countries as Nigeria, Kenya, Côte d’Ivoire and Indonesia), traction has been limited.  

Three key insights

1. Institutional investors are largely hesitant to invest in smallholder agriculture. Institutional investors have very limited risk appetite and we’ve seen limited success in engaging them. Our ongoing study with ISF Advisors confirms this point. If institutional investors don't have a clear mandate to focus on smallholder agriculture, they often have limited incentive to do so. Even those with an impact or sustainability focus, tend to find better options in other sectors.
2. Local traditional financial institutions have better options elsewhere. Many of the banks which we’ve spoken to want more guarantees than we can offer. Larger commercial banks and local banks are much more comfortable in buying government bonds or dealing with large corporates, whilst other sectors ultimately compare better from a risk-adjusted returns point of view. As a result, we believe that innovative approaches are essential to mobilise local banks. We’ve watched with great enthusiasm as initiatives such as Aceli have shown good success in moving local FIs through offering incentives to increase investment into smallholder agriculture. Similarly, our own investments in Avanti, have sought to support the traditional banking sector by targeting intermediaries
3. MFIs have great impact potential but many need substantial TA. We pivoted towards MFIs to facilitate more lending to smallholders. They are more impact-oriented and often more rural, which aligns more with the Fund’s vision. We’ve made a number of investments including Advans Côte d’Ivoire, Agora MFI and Aldea MFI in the last few months. However, research that we commissioned from the Centre for Financial Inclusion emphasised that substantial TA is needed to help digitise MFIs to better serve smallholder farmers and to also present a stronger investment case for the funders.

3) Equity is an important driver of impact and additionality 

At the beginning, we expected to pursue a lot of farmer on-lending transactions by large multinational traders where our main instrument would be debt. However, we designed the Fund with the flexibility to better meet the demands of the sector in case our assumptions didn’t hold and to allow meeting our impact objectives through other mechanisms. Equity has proven an essential tool in allowing us to be more flexible. As a result, we’ve increased the maximum equity exposure to 30% of the total Fund’s size.

Three key insights

1. Equity can be more transformative as a mechanism for change. Equity has allowed us to better target deals that we believe can be transformative for the sector or can generate new financial models. These more innovative business models are often young and lacking the cashflows to pay debt, thus equity or mezzanine is often better suited if we want to engage. By taking an equity position, we are also better positioned to use our expertise to guide investees.
2. Providing equity is a possible lever to facilitate more affordable loans to smallholder farmers. MFIs are an excellent channel for reaching smallholder farmers, but interest rates can be prohibitively high. Through our equity investments, we believe that by reducing the cost of capital and investing in improved processes for MFIs, and through investing in fintech companies to enhance delivery mechanism efficiency, we in turn can see lower interest rates for smallholder farmers.
3. Equity is not without its own challenges to our operating model. Two key downsides to our use of equity are the impact on the liquidity of the Fund and the uncertainty it brings around exits. While a loan generates early liquidity and there is repayment built in, this isn’t the case with equity. Not only does this affect the Fund’s cash flow position, but as a close-ended fund, we have mostly needed to direct our equity investments to mature markets where we can be more confident of an exit.

 4) Our investment guidelines have led to rising ticket sizes 

The IDH Farmfit Fund was designed offering a wide range of possible ticket sizes to address the huge demand for capital in the sector. Comparatively, we are targeting lower ticket sizes than many investors headquartered in the global north such as Development Finance Institutions (DFIs) and other Impact Investors. However, our ticket sizes have increased over the past five years. The three deals currently in contracting will see it rise further to a level we expect it to remain at going forward.

Three key insights

1. Our investment guidelines aren’t aligned with smaller ticket sizes. The fact that we are always co-investing with other investors and have strong impact criteria means a heavy due diligence process relative to our deal participation and the nature of the companies we had been targeting. This process takes a lot of time and also comes as a cost. These transaction costs make less commercial sense for lower sized transactions.
2. We’ve adjusted our maximum participation in light of ticket size limitations. For the first few years, we were largely limited to a maximum of 30% participation in transactions. We observed that total deal sizes including co-investors would often be around €10M. To still reach companies who are less able to absorb this size of investment, we have increased our maximum participation rates to 50%, dependent on the total transaction size
3. There’s still a considerable gap for investments of a certain ticket size. Many DFIs and impact investors are operating in the $5m+ space, whereas a lot of local funds are active in the <$500k space. We’ve seen many opportunities with smaller ticket sizes, but unfortunately, these would have been economically unviable and hurt the deployment rate of the Fund. Fortunately, this last year has seen new initiatives that show potential to fill this gap such as Financing Agricultural Small-and-Medium Enterprises in Africa (FASA), One Acre Ventures and AgDevCo Ventures.

5) It’s been harder to find cocoa investments that fit our goals 

The cocoa sector has faced significant challenges in recent years, with climate-related events and concerns being a major factor driving price volatility. For the Fund, finding cocoa deals that align with our investment approach and impact mandate has been challenging. Currently, cocoa investments represent 13% of our total portfolio.

Three key insights

1. Cocoa is a crowded investment space. For many investors, the fact that cocoa is traded in hard currency reduces the risks in investing in this sector. In fact, cocoa transactions represented around 25% of sub-Saharan Africa disbursements of CSAF members with many investors focused on trade finance. the Fund's commitment to additionality, means we are not competing in the cocoa trade finance market and are aiming to find other impactful opportunities in the cocoa sector.  We invested in Koa, an innovative enterprise that converts cocoa byproducts into other products to help farmers earn more from their harvest and we invested in the cocoa sector through Advans, enabling farmers to diversify their income by investing in other crops.
2. On-lending transactions with commodity traders are not easy. One of our earlier hypotheses was that we could support on-lending to smallholder farmers in coffee and cocoa value chains through multinational traders in similar transactions to the Coffee Smallholder Livelihoods Facility with Neumann Kaffee Gruppe. However, such facilities are more the exception than the norm, given the complexity to structure and the fact that most traders want to focus on their core trading business and on-lending poses many risks.
3. “It’s complicated” goes beyond the IDH Farmfit Fund. According to CSAF, 2022 and 2023 saw decreases in cocoa disbursements by their members. Droughts, flooding and crop diseases are negatively affecting yields in many cocoa communities. The associated surge in global cocoa prices created considerably challenges from Agri-SMEs including their ability to secure supply and demand from their buyers.

Reflecting on the past five years, we realise that each lesson learned has brought us closer to our goal of making smallholder finance a viable asset class. Our commitment to learning and sharing our insights is embedded in the DNA of the IDH Farmfit Fund. As we continue to build a sizeable portfolio, we will continue to invest in creating and dissemination insights from our own portfolio as well as taking part in broader stakeholder groups such as the Agri-SME Learning Collective and the Council on Smallholder Agricultural Finance. 

In the coming months, we will publish a more in-depth insights report. Interest to receive this, please keep an eye out on the Farmfit Insights Hub and sign up to the Smallholder Inclusive Business Newsletter.