By Ellie Winninghoff

When it comes to investing in wine, the old saw goes something like this: How do you make a small fortune from a vineyard? Start with a large fortune.

In the quest for alternative investments, the business of wine is a fringe player that's getting more attention. Institutional investors such as Calpers, TIAA-Cref, Prudential and John Hancock are investors in vineyards. Individual investors can partake through private-equity opportunities, or through the public markets via real estate investment trusts.  

That can be quite different than investing in or buying wineries--something that has been especially popular among so-called lifestyle investors who have made their fortunes in other pursuits. Last year, for example, real estate magnate Donald Trump and AOL founder Steve Case and his wife Jean acquired wineries in Virginia.

One way investors can participate directly in vineyards is through wine REITs, which consist of sale-leasebacks that allow wineries to take their capital-intensive vineyards off the books. Silverado Winegrowers and Silverado Premium Properties, which operate roughly 10,000 acres in California, introduced the sale-leaseback to California vineyard owners in l982. It has done 12 sale-leasebacks as private deals, but won't divulge returns.

In recent years, two publicly traded wine REITs--Vintage Wine Trust and VinREIT, a part of Entertainment Properties Trust--ran into trouble. "Other than Silverado, wine REITs have not done well," says Neil Campbell, CEO of FUTR Family Management, based in Carlsbad, California.

That could change.

In June 2010, Escondido-based Realty Income Corp. purchased vineyard and winery properties from Diageo Chateau and Estate Wine for $269 million in a private auction. With 2,000 acres in Napa, and real estate owned by Sterling Vineyards Winery and Beaulieu Vineyards, a back-of-the-envelope calculation suggests the REIT obtained the properties at an astonishingly good price. The wineries will operate the properties and retain ownership of the vines. But in a different twist, Diageo plc has guaranteed the triple-net lease.

In the wake of the financial crisis, observers predicted widespread bankruptcies and foreclosures among California's 2,400 wineries. That did not happen. But where there were problems, lenders put pressure on wineries to sell, and they did, says Mario Zepponi, a winery and vineyard investment broker with the Zepponi Group in Santa Rosa, California.

Last year, 31 wineries were sold. That was "a big number," says Mark Freund, Senior Relationship Manager at Silicon Valley Bank, based in Santa Clara, California, whose clients include 360 wineries and vineyards.

But according to a survey published by Silicon Valley Bank and Scion Advisors in 2008, 60 percent of the respondents said they would undergo an ownership or generational transition by 2017.

"This is an enormous change for such a small industry to absorb," the report said. "The large number of retirements will produce a power shift throughout the industry that could have ripple effects."

Private Equity
Bacchus Capital Management LLC, based in San Francisco and New York, is uniquely positioned to ride this wave in a substantial way. Rather than just buying wineries, co-founder and managing partner Peter S. Kaufman says the private equity firm provides "flexible capital" (control equity, first lien or mezzanine/second lien debt) that wineries can use to finance growth, intra-family transitions, or acquisitions of other wineries.

The firm focuses on growing wineries  "where we can add value," adds co-founder and managing partner Sam Bronfman (older brother of Edgar Bronfman Jr.), a wine industry veteran. Describing the wholesale/retail system as an "hour glass with a tiny narrow opening that most small owners can't get through," he explains that distributors decide which wines will be sold. He says he can use his own relationships to assist wineries in this matter.

Bacchus has provided debt financing to Cameron Hughes Wine, Andretti Winery, Wine by Joe and Qupe. In October, it invested equity in Sbragia Family Vineyards, whose founder Ed Sbragia is the only winemaker in the world to have received a Wine Spectator #1 wine of the year award for both a red and white wine.

"We're trying to make this a little more mainstream," Bronfman says. "We have a lot of investors who just like the idea of investing in the wine business--investing in wineries as opposed to investing in Bordeaux futures or investing however else people quote invest unquote."

Sour Grapes
Most wineries are small businesses run by owner-operators. Average sales are $3 million. But with millions of dollars often tied up in real estate often worth $225,000 per acre for non-trophy vineyard property in Napa, it's never been an easy business to make money in.

And it has become a heck of a lot harder since the financial crisis. There are 7,000 wine brands in the US. Some are sold direct. But vying for shelf-space against giants like Constellation or Diageo that also sell spirits with higher profit margins for distributors, is no easy task.   

"Unless it's a great brand that sells itself, most of these distributors don't want to promote these brands," Freund says.

At least one large institution has learned the hard way just how difficult the wine business can be. Insurance companies and insurer-backed growers have been particularly active in vineyards. And some have been at it for decades. Among the players: Travellers, Mutual of New York and Met Life Vineyards, as well as John Hancock and Prudential, according to Robert Smiley, wine economist and professor emeritus of management at the UC Davis Graduate School of Management.  

CalPERS, however, is said to be making an exit. In October, it fired Premier Pacific Vineyards (PPV), a Napa-based vineyard development company in which it had invested $200 million. By March 2011, the value had plummeted 40 percent. The properties are unofficially on the block, and CalPERS has hired Menlo Park-based GI Partners to manage the investment.

"There are a lot of people interested in those vineyards for the right price," Freund says. "CalPERS does not want to piecemeal the sale of these properties. They are huge parcels--too big for most wineries to buy. But [wineries] could form a partnership and buy them together and divide the fruit."

What went wrong? The value of the land, after all, did not decline. And according to Zepponi, there is "very little risk" associated with investing in vineyards compared to wineries. "When it comes to the low end/high end, you have to buy it right and farm it right," he says.  

Of course, low-risk is not no-risk. David Freed, chairman of the highly successful Silverado Winegrowers and Silverado Premium Properties, has argued for years in favor of pre-plant contracts.

"People have been hurt by treating it as a spot situation and worrying who the buyer is going to be when the trucks are pulling out of the vineyard," he says, pointing out that half his payroll consists of seasoned marketing people deeply knowledgeable about grapes. "We've had most of our grapes pre-sold going into each harvest."

Targeting the very high end of the super-premium wine market ($25 and up), PPV developed properties in California, Oregon and Washington. It rode the high-priced Pinot Noir wave before the Crash, and it sold three properties it developed in 2007 and early 2008, reportedly at double-digit returns. But when the economy collapsed and consumers traded down in wine prices, it couldn't sell its fruit.

"Nobody could make reasonably priced wine with high-priced fruit," Zepponi says. "And certainly nobody was going to be signing long-term contracts, particularly with high priced fruit."

The PPV (ie CalPERS) vineyards are massive. Although not yet developed, for example, the plans for the highly controversial Preservation Ranch in Sonoma County involve clear-cutting 1,700 acres of Redwoods, a gravel-mining operation, industrial-scale water diversions and building 90 miles of roads.

"[PPV's] vineyards are first-class," Freund says, "but the cost was above and beyond what anybody else had ever spent. They were dynamiting out stone to get these vineyards in."

And for a grape grower, it was a relatively high-risk strategy.

Vineyards are 30-year investments that require three years to get a crop (and cash flow), five or six years for the crop to mature, and seven years to earn a return. PPV developed all of its vineyards from scratch, a process that PPV co-CEO Dick Wollack described as a "a different kind of VC investment" in a San Francisco Chronicle article from January 2001.

The Silverado funds also develop vineyards from scratch. But development only accounts for a small portion of total acreage at any given time. "[Most of our property] is producing income," Freed says.

And whereas PPV limited itself to producing grapes for the highest end of the wine market, Silverado is as diversified as possible.

"If there's a weather problem in Santa Barbara, there may not be the same problem in Sacramento," Freed says. "And being in diversified markets is critical. We have 150 customers in all the varietals, and most of the price points up to $100 [per bottle.]"

More Sweet, Less Acidic?
Last year may have proved to be a turning point for both California vineyards and wineries.   

After the most difficult few years in the history of the California wine industry when, post-financial debacle, consumers downshifted away from pricey Napa brands to cheaper vintages, demand for super-premium priced wines is climbing again. Sales of $20-plus wines grew at double-digit rates in both 2010 and 2011, according to Freund. Sales for under $3 and $6-$8.99 wines dropped last year.   

In late 2011, the market for grapes suddenly shifted from a buyers' market to a sellers' market, Zepponi says.

"There has just not been a lot of acreage planted over the last few years," he says.  "Wineries are trying to secure sourcing for their fruit not just for this year but on a multi-year level.

"It's the worst kept secret," he adds. "Everybody knows it now. We have to plant more fruit."

For people who invest in this tricky market, perhaps that will help them harvest better returns on their investments.

A former investment banker and veteran financial reporter, Ellie Winninghoff can be reached at: ellie.winninghoff (at) gmail.com.