For all its climatic hostility, the Ampara district is known as Sri Lanka’s ’rice bowl’. In 1949, a year after independence from British occupation, an ambitious irrigation project creating the Gal Oya Reservoir commenced. Popularly known as the Senanayaka Samudra – after Sri Lanka’s first Prime Minister D S Senanayake – the reservoir, completed in 1953, made large-scale rice farming year round in the Ampara district viable.

The Ampara district is a hostile environment – five degrees hotter and receiving half the annual rainfall compared to the wet zone.

Ampara’s dry weather best suits another crop: sugar cane. It needs a tenth of the water rice consumes and generally offers better farmer incomes because the crop requires little maintenance and effort, leaving farmers free to earn a living doing something else. Seeing this potential, the planners of the Gal Oya scheme recommended that the Hingurana region be allocated for sugarcane, anticipating that demand for sugar will grow.

For 2,000 years, rice has been Sri Lanka’s staple food and main source of carbohydrate for people. Rice farmers are venerated because they were the only defense against mass famine. Sugar is a fairly recent addition to Sri Lankan diets. Before sugar was imported here, Sri Lankans used honey and treacle to make food sweet.

Sri Lanka has an on-again, off-again policy approach towards sugar as an imported commodity and sugarcane farming here. Sri Lankan per capita sugar consumption at 31 kilograms annually is higher than the estimated global average of 25 kilograms. Sugar – despite its contribution to obesity and other health effects – is a major source of energy for most people who consume it in food and drink.

Just as rice is central to Sri Lankan diets and its price a matter of political concern, so is the price of sugar. In July 2016, along with price controls on rice, the government also slapped a Rs95 ceiling on the retail price of sugar. At the same time, the Finance ministry slashed the commodity levy on sugar to twenty five cents from Rs30 a kilo. Imports supply 92% of Sri Lanka’s sugar requirement. In 2015, sugar import levies were cut Rs10 to Rs18, and in September the same year, increased again by Rs12. The 2015 import levy reduction followed a Presidential election and its increase a few months later, the government claimed, was a measure to prop up prices for local producers.

The government also increased the minimum farm gate purchase price to Rs4,500 in 2015 – an election year – from Rs4,100 in 2014. Sugar plantation companies’ profits taxed at 28% was reduced to 12% that year as well to benefit companies in the sugar industry, all of them government controlled.

The local sugar industry is also protected at consumers’ cost. Sri Lanka imports around 650 million kilograms of sugar annually, and if it imposed taxes and levies of Rs30 per kilo, annual government revenue would top Rs19 billion. Levies and taxes on sugar are frequently meddled with, but it’s likely this estimate is not far off from the outturn.

Gal Oya Plantations – a government controlled but private sector managed sugarcane plantation and sugar refiner – endures enormous risks due to wild commodity policy swings. Local sugar producers have benefited from highly taxed imports and been hurt by controlled prices. Policy inconsistency isn’t limited to price controls and frequent import levy tweaking either.

In 2011, the government acquired two successful privately owned sugar refineries and plantations, Sevanagala and Pelwatte, without justification or fair compensation to their private owners.

Higher risks, limited opportunity to scale and unpredictable policy have steered private investment away from agriculture. The sector is also exposed to greater natural risks. In 2015, Gal Oya Plantations and outgrower farms were flooded, destroying more than a quarter of the sugarcane crop, reducing refined sugar output by a similar volume.

 

In 2008, LOLC, a listed company with interests in leasing and financial services, and its subsidiary Brown & Company invested equally to acquire a 49% stake and management control of government-owned Gal Oya Plantations and its disused sugar refinery. They invested Rs495 million for the minority stake.

It did not take long for the company to realise that it will not make profits within the next 10 years at worst. It discovered that it had taken on a risk far bigger than its due diligence as on-site inspection of the refinery suggested. It expected to make profits by 2014, but this was not to be. However, the company continued to invest and in the process improved the living standards of the farmer community at Hingurana.

In the face of an alarming rise in global food prices a decade ago, the government decided to revive sugar production at the Gal Oya refinery through a public-private partnership. It faced a balance of payments crisis – which required an IMF bailout later in 2009 – and figured that growing local sugar production will reduce imports.

A new company, Gal Oya Plantations was incorporated, to which all the assets of the defunct Hingurana Sugar Industries were transferred or leased. Included were a sugarcane refinery and 500 acres of land for a nursery. The sugarcane was to come from 13,000 acres of cultivatable land surrounding the factory, allocated among 4,400 families.

In 1960, the Scottish built and gifted the Hingurana Sugar complex in the Gal Oya region, which lies at the midpoint between the Senanayaka reservoir and Ampara coast. The government demarcated around 13,000 acres of state land for sugar cultivation in the region and a family was allotted around 2.5 acres to cultivate sugarcane. These families didn’t own the land, their names were simply entered in a register maintained at the Gal Oya factory. The Scots operated the factory for three years before the government was ready to take over operations.

A farmer harvesting sugarcane on a 2.5 acre plot profits around Rs300,000 annually without breaking a sweat; whereas rice, a semi-aquatic crop, usually generates a profit of around Rs180,000 annually, but requires 10 times as much water and constant attention. Costs of inputs like fertilizer and weedicides greatly reduce profitability of rice.

Hingurana Sugar Industries – as the firm was then known – produced an average 9,700 tonnes of sugar per annum between 1969 to 1990, available data shows. The company was privatised in 1990. The new owners went out of business five years later and the factory shut down, leaving sugarcane farmers with no buyer for their crop. Without other options, farmers switched to growing rice.

In the early 2000s, two government-owned and privately managed sugar manufacturing companies, Pelwatte and Sevanagala, which had their own outgrower cultivated plantations, convinced some Hingurana farmers to recommence growing sugarcane. However, this arrangement soon fell apart because the cost of transporting produce to these refineries was uneconomical. Pelwatte’s sugar refinery was 106km south-west from Hingurana and Sevenagala’s was 74km further down the Colombo-Batticaloa highway. Farmers now twice bitten by private companies abandoned the crop a second time, turning to rice once more.

When LOLC-managed Gal Oya approached farmers 15 years later, the reception was sometimes cold and often hostile. “No one was growing sugarcane, most had switched to rice and some land was abandoned. They mistrusted private businesses,” Gal Oya Plantations Chief Eexecutive Gamini Rathnayaka recalls. “The problem was clear: we had to convince farmers to switch to sugarcane or risk losing our investment.”

He vividly recalls being confronted by angry farmers armed with clubs who surrounded a group of people working for Gal Oya Plantations. The people were clearing some abandoned fields to prepare the soil for sugarcane, which the mob of farmers claimed belonged to them. They feared Gal Oya Plantations was attempting to seize their land.

Rathnayaka and chief operating officer Danesh Abeyrathne failed to reason with angry farmers and worried for the safety of their workers. The mob hurtled abuse, pushed and shoved, but the company men didn’t yield.

For Rathnayaka, an agriculture economist, and Abeyrathne, an engineer and accountant, the experience was unsettling. The police later restored order, but a few company workers were battered and bruised, and a few were hospitalised to treat minor injuries. Rathnayaka and Abeyrathne, shielded by the workers, were unhurt. They claim the experience hardened their resolve to win over these farmers to sugarcane.

The hostility refused to fade. One farmer filed a fundamental rights application in the Supreme Court, arguing that a private company was violating his right to engage in rice cultivation.

Supreme Court judges studied the Gal Oya irrigation project’s objectives set in the late 1950s and noted that the Hingurana area was demarcated for sugarcane by a gazette notification, Abeyrathne says. “The judges ruled in our favour, so we had a court ruling that 13,000 acres around the sugar factory was for growing sugarcane.”

However, Rathnayaka engaging over 4,000 farmer families bore no results. “First show us smoke rising from the chimney, then we will plant sugarcane,” an incredulous group of farmers responded. Expectations of getting the factory operating soon were also optimistic.

As the machinery hadn’t been cleared of sugarcane before being shut down when the factory went out of business in 1995, the thick pulpy extracts had rotted and rusted the machinery worth tens of millions. Under LOCL management, the factory produced no sugar in the first four years. The company struggled to fund the cost of repairing and upgrading the factory.

“It would have been cheaper and faster to demolish the refinery for scrap and build a completely new facility,” Gal Oya Plantations’ Chief Operating Officer Abeyrathne says. But the agreement with the government forbade selling assets. The company was forced to renovate instead, and replacing components that weren’t fixable. “It’s a mix of old and new,” Abeyrathne says about the resulting facility.

 

Gal Oya was unable to raise equity to fund repairs, upgrades and operational costs, as its controlling shareholder –the government – was unable to invest or allow an LOLC investment to dilute its majority stake. Banks were unimpressed by sugar milling economics and unwilling to lend to a business without revenue. Its only source of funds was LOLC group loans, and that was controversial for two reasons.

LOLC Group includes three listed firms – one in leasing (LOLC) and two non-bank finance companies (Lanka Orix Finance Company and Commercial Leasing and Finance) – that mostly lend to small businesses. “Pressuring them to lend to Gal Oya at 15-18% interest rates was tough when they were making over 25-30% lending to SMEs,” LOLC’s Chief Legal Officer and Gal Oya Plantations Director Kithsiri Gunawardena recalls.

“Chief executives naturally wanted higher returns. That being said, LOLC shareholders and directors realised Gal Oya was now their baby and we had no choice but to make it work. We had to invest”.

The LOLC-Brown Rs495 million equity investment money vanished within two years.

Between 2008 and 2012, Gal Oya Plantations spent nearly Rs2 billion getting the factory in working order, paying staff salaries, investing in plantation infrastructure and purchasing sugarcane from farmers. However, the company was not making any sugar, and therefore not making any money at all. That was the first controversy.

Government representatives of Gal Oya’s board raised alarm about increasing debt – sourced from LOLC Group. This was the second controversy. Their worry that the loans were obtained at uncompetitive interest rates, increasingly exposing itself to LOLC Group, led to tension at board meetings. “What else were we supposed to do?” Gunawardena asks. “We had to keep lending to Gal Oya Plantations to turn it around. They now understand.”

Managing contrasting expectations made it difficult to focus on the more important job of affecting a fast turn around and high returns.

“My God, it was a nightmare! Managing operations was challenging enough, we also had to manage the expectations of government sector directors in Gal Oya Plantations’ board and the concerns of related party companies in the LOLC Group,” Gunawardena says. “It’s always a question of us being able to convince the board to have faith in our ability to turn things around”.

 

Gal Oya Plantations completed factory renovations in 2012, four years after LOLC took over its management. It crushed sugarcane grown in less than 2,000 acres, around 15% of the total cultivatable extent, because most farmers were still skeptical.

The mill produced 3,300 tonnes of brown sugar that year. The refinery’s annual capacity of 40,000 tonnes needed more sugarcane. The next year, the factory produced 10,500 tonnes of sugar, more than tripling, as farmers gained confidence.

Farmers had been slow to convert their fields from rice to sugarcane. Two years since taking over management at Gal Oya Plantations, LOLC had been able to convince farmers to plant sugarcane in only 630 acres out of 13,000.

During this period, while racing to get the refinery working, Gal Oya engaged farmers to grow sugarcane by undertaking to transport the produce to another refinery even when it was unable to buy the produce for use at its own. When its factory wasn’t ready, it transported produce free to sell crops to Pelwatte Sugar Industries 100 kilometers away. It also undertook to provide free seedlings and soft loans for fertilizer. Its officers visited temples and mosques to convince religious leaders in Hingurana.

Goodwill was important. So LOLC offered more incentives, like loans to help prepare land for planting. It paid half the insurance cover against bush fires and occasional floods that destroyed crops. Gal Oya Plantations upgraded the road and irrigation networks, spending Rs30 million annually on maintenance. Another Rs30 million funded an electric fencing to keep wild elephants out.

When the refinery was finally completed in 2012, the area under sugarcane cultivation was less than 2,000 acres. Noticing rising smoke from its steam-fired boilers for the first time in 15 years, a group of farmers decided to inspect. “They wanted to make certain that the smoke was due to sugar refining and not us burning firewood to trick them into growing sugarcane,” Rathnayaka says. “Look, I told them, we are really making sugar!”

The following year, the acreage under cultivation grew five-fold to 8,500 acres, and peaking at 8,900 acres in 2014, but this was still 68% of the cultivatable extent. In three years, sugar production increased from 3,300 tonnes in 2012 (the first year of operations) to 19,900 tonnes in 2014.

 

In 2008, assets allocated to Gal Oya Plantations were valued at Rs516 million. This was the government’s contribution for the 51% controlling stake in the venture. The government made it clear that it was unwilling to invest any more, so the LOLC-Browns consortium invested Rs495 million in the balance 49% stake. “We didn’t have a say in valuations,” Gal Oya Plantations Chief Executive Rathnayaka says about discovering that the factory was rundown after the deal was inked.

Browns, popularly known as Brown & Company PLC, is listed and a market leader for car batteries and has subsidiaries in financial services, manufacturing and hotels, and manages several tea and rubber estates. Sugar milling was a diversification opportunity for the firm, which was lead by Ajith Devasurendra in 2008. Browns was then controlled by a company called Diriya Investments through a web of other companies, including Mason’s Mixture and Engineering Services, which together had a 49.8% stake in Browns.

LOLC held half of equity in Diriya Investments and Devasurendra the rest. Independently, LOLC held a further 4.7% stake in Browns, which gave it control.

The Nanayakkara family controls LOLC. Ishara Nanayakkara, its deputy chairman, and Devasurendra were promoters of listed investment bank and primary dealer Taprobane  Holdings, and sat on the boards of several listed companies including Seylan Bank.

Devasurendra initiated acquiring equity and management control of Gal Oya Plantations. “It was Browns’ baby at first,” says Kithsiri Gunawardena, LOLC’s chief officer of legal and operations, and director at Gal Oya Plantations. In 2012, LOLC gained control of Browns by acquiring the 50% of equity in Diriya Investments from Devasurendra for Rs1.3 billion. With the acquisition, LOLC assumed sole responsibility for managing Gal Oya Plantations. Until then, LOLC had remained the passive partner at Gal Oya. “Browns took the lead and we were happy to follow,” Gunawardena says.

In 2008, none at LOLC or Browns had a clue about the challenge Gal Oya posed. In Brown’s due diligence ahead of the acquisition of the sugar refinery, it forecast an annual return on investments of up to 30% from 2015 onwards. After the acquisition of Browns, LOLC’s total lending exposure to Gal Oya Plantations amounted to Rs3 billion by 2016, and the sugar company is not expected to make profits until 2018.

LOLC and Browns lacked the skillsets to manage a sugar refinery. Their inspections of the assets, including the refinery, before signing the investment agreement with the government somehow didn’t expose the shortfalls in their assumptions. They wrongly assumed that the refinery was in running order and expected profits in 2014, seven years after taking over management.

By March 2015, Gal Oya had accumulated Rs2.2 billion in losses instead. “It’s like a black hole. We keep losing money,” quips Gunawardena.

Making money is difficult for two reasons. First, Gal Oya does not enjoy scale. Gal Oya Plantations operates in an environment where profit making is impossible by producing sugar alone. According to government controlled pricing, the company sold a kilo of sugar at Rs62, which cost Rs120 to refine in 2015. Second, the company has huge loan servicing and administration costs.

The sugar producer reported a Rs300 million gross profit for the first time in 2014, two years after the factory began producing sugar and more farmers began growing sugarcane. That year, the refinery produced a record 19,900 tonnes of brown sugar, with 8,900 acres under cultivation. Before then, the factory’s best performance was in 1978 when it produced 15,700 tonnes of sugar from 13,000 acres. But the turnaround in gross profits was short lived.

The government cut duties on imported sugar and increased the minimum sugarcane purchasing price in 2015. That year, floods destroyed a third of the sugarcane crop. “All this hit us badly just as we were making progress. We made a Rs300 million gross loss that year,” Gal Oya’s Head of Operations Abeyrathne says.

Despite record production and making an operating profit of Rs300 million in 2014 (for the first time since 2008) from sugar production, Gal Oya reported a net loss of Rs555 million that year. This was due to high administrative costs of Rs391 million, including the maintenance of plantation infrastructure and finance costs amounting to Rs495 million, servicing Rs4.2 billion worth of loans, which includes loans from two state banks amounting to Rs1.2 billion and the rest from LOLC Group. In 2015, the net loss had expanded to Rs894 million.

 

Refining sugar, even in the absence of scale, can be lucrative because its by-products are free inputs for several lucrative associated ventures. Crushed sugarcane waste is used as fertilizer or landfill, biogas generation during the sugar milling process can be harnessed to produce electricity to power the factory or sold to the grid, and carbon dioxide emissions trapped and stored to be sold as an industrial input in beverages and pharmaceutical manufacturing. But the biggest source of profit is ethanol, a biofuel produced from molasses, a by-product of sugar refining.

When the Scots built the Hingurana Sugar Factory in 1960, they also built a distillery to produce ethanol, which went into arrack brands that locals called ‘gal arrakko’.

In 2008, when LOLC took over management, they found the distillery in ruins. Nothing could be salvaged, so the facility was dismantled for scrap. The company invested Rs850 million  to build a new one.

The Gal Oya factory has a capacity to crush 2,000 tonnes of sugarcane a day. Of this, 8% or so ends up as brown sugar, which is packaged in 50kg sacks and sold mainly to supermarket chains that retail the crystals under their own brand names. The by-product molasses will be diverted to the distillery to produce 21,500 litres of ethanol a day, which currently sells for around Rs275-300 a litre, wiping out the loss of around Rs25 to produce one kilo of sugar.

Gal Oya is not betting on the distillery alone.

In 2017, the company will invest in a 10MW power generation plant, which will come into operation in early 2019 fuelled by plantation waste. It will use 2MW to power the factory and the balance will be sold to the national grid. Gal Oya will also trap carbon dioxide emitted in its furnaces, which will be diverted to the beverage, breweries and pharmaceutical industries.

Another by-product, press mud, which comes in the middle of the sugar making process when lime is added to sugarcane extract to remove impurities, will be diverted to LOLC Group’s fertilizer manufacturing firm Agstar, which it owns through Browns.

These initiatives are expected to improve revenue and cut costs, increasing profitability going forward. Revenue is forecast to grow from Rs2.8 billion in 2016 to Rs5.3 billion in 2020. The company projects losses to narrow to Rs11 million in 2016 and turnaround the following year. In 2020, profit is projected at nearly Rs2 billion.

“We’ve had to bleed money all these years to make this happen. The LOLC board and shareholders have faith in us, and even banks started lending when they understood what we were trying to achieve,” Gunawardena says, expecting to breakeven by 2018.

Annual return on investment is forecast at 20-25% after 2018 with the distillery alone. Add the fertilizer, carbon dioxide and power generation facilities, return is expected to be over 30%. “More importantly, Gal Oya will be debt free by 2022,” Gunawardena says.