In this article, which was published in the Mining Journal on July 12, 2013, BLP partners Alexander Keepin and Michael Weir outline the growth trend and benefits of private equity as a source of capital for mining companies.
Private equity investors express growing appetite for mining sector
Market volatility makes it difficult for companies to plan ahead for large projects that may take years to show meaningful financial returns and continuing economic uncertainty and instability have had a significant affect on the availability of traditional sources of funding on which many mining companies have historically relied. According to data compiled by Bloomberg, bank financing to metals and mining companies slumped to a three-year low in 2012, as banks reduced their exposure to risk assets, while equity sales in the mining industry dropped 49% against 2011 levels. Meanwhile, the share prices of many mining companies have slumped.
The combination of these factors has left many miners (particularly mid-tier and junior mining companies) anxiously seeking alternative sources of financing, with continuing pressure to complete tens of billions of dollars of capital projects to meet forecast increases in global demand. Bloomberg reported in April that four out of 10 miners have less than three months of cash on hand, based on a review of financial statements of 101 mining companies from London and South Africa, and current market pressures show no imminent signs of abating. Faced with these on-going challenges, mining companies are increasingly looking to private equity (PE) and funds as a potential source of capital, particularly for early-stage or junior resource projects.
Many firms already appear to be poised to take advantage of this opportunity, with Boston-based Denham Capital Management Ltd raising US$3 billion last year for resources deals and Toronto-based Waterton Global Resource Management putting aside US$1 billion to invest in precious metals projects and companies. Both investors have already been linked to commodity trader Trafigura Beheer BV, which is reported to be considering its first foray into PE investment. While PE investors have traditionally eschewed natural resources, principally because of a lack of predictable cash flow, they are now showing a growing appetite for the sector. There is evidence that such investors are already considering innovative ways to manage the cash flow issues in order to capitalise on the opportunities afforded by current market conditions, including hedging commodities production (which listed mining companies would typically avoid).
There is substantial evidence of growth in this sector from a number of sources. According to statistics collated by Ernst & Young, private capital accounted for 21% of the US$76.8 billion spent in mining mergers and acquisitions in the first nine months of 2012 compared with 12% for the same period in 2011, while Bloomberg reported in April that the amount of capital raised by PE in the mining sector in the 16 months to April 2013 was higher than the total raised for the previous four years combined. Funding is also coming increasingly from sovereign-wealth funds based in Asia and the Middle East, some of which are diversifying their portfolios out of oil and gas into other extractive industries. Last year saw Chinese buyout firm Cathay Fortune Corp bid A$830 million (US$753 million) for Australian Copper miner Discovery Metals Ltd, while January 2013 saw Delphi Holdings Sàrl, the Luxembourg-based investment holding company ultimately owned by PE fund Rhone Capital LLC, acquire a 38.74% stake in S&B Industrial Minerals SA, and Korea-based PE firm EQ Partners partnering with POSCO, China Steel Corp and National Pension Service to acquire a 15% stake in Mont Wright and Fire Lake from ArcelorMittal for US$1.1 billion in cash.
More recently, Areva SA has expressed an interest in examining any opportunities in relation to Urenco and it has been reported that PE firms Apax Partners, Carlyle, KKR, Blackstone and TPG are also considering investment in mining. PE house Ethos is said to be looking at an acquisition of an interest in the non-core assets of South African mining group Anglo American plc, while news outlets have stated that KKR is in talks with Rio Tinto for the sale of its 80% interest in the Northparkes copper mine, although this has not been confirmed.
As a good indicator of the increasing maturation of this market, reports have also emerged of potential secondary private equity investment in the mining sector, with Orient Mining Resources, a company wholly owned by PE firm Orient ES Capital Group, reportedly expressing an interest in selling shares equivalent to 35-40% of the company to strategic investors or other PE firms. Current funding difficulties for mining companies look set to continue for much of 2013. These difficulties, combined with depressed share prices and continued pressure to deliver on capital projects, have created, as Gareth Turner, a senior partner at Apollo Global Management LLC is quoted in a recent Bloomberg article as saying, “the perfect backdrop for private-equity capital”, a backdrop which seems set to provide significant opportunities for PE investment for some time to come.
How does private capital work?
PE houses and funds have traditionally tended to favour early-stage projects over later-stage projects that require more significant investment and which still generally rely on public fundraising, debt or existing company resources. Private investors may also specialise in niche metals or regions with high growth prospects. However, as PE investors and funds become more established within the mining industry, they are increasingly looking to scale up their average investment size to more significant later stage projects.
One advantage that a PE house or fund can have over the public markets is the degree of resource it can bring to bear on becoming familiar with a specific investment, although a corollary of this is that PE/fund due diligence has additional areas of focus. In addition to the geological review and assessment of the political and jurisdictional risks, the PE due-diligence process also focuses on the mining company’s management and their experience. The management team can often be the critical factor for PE and funds when assessing an opportunity.
Key factors in any due-diligence process include assessing the potential for the PE investor or fund to exit its investment within its investment horizon, as well as the potential for the asset to grow in value. Exit options are dictated by when the investor wishes to sell its equity holding. Options for an exit centre around a public listing, a “trade” sale to another corporate or a “secondary” sale to another PE house. PE investors generally require their project partners to have sufficient faith in the project’s prospects to contribute a significant amount of their own capital to a project alongside the investor.
There is a focus on achieving success by keeping interests aligned. A management team with an equity stake can be strongly encouraged to perform well to grow the business and achieve value growth on its initial capital outlay. The investment is typically governed by an investment agreement (potentially alongside the constitutional documents of the target company or project vehicle), under which an investor may take either a controlling or minority interest in the target company or project. With such an arrangement, key negotiation points centre around the initial capital contributions, incentive payments to the management team and the cost of capital, which will be influenced by the investor’s target rate of return and the length of its investment.
In the wider economy, PE houses look to leverage their returns by the use of debt provided by banks, the bond market and other financial institutions such as mezzanine providers. A leveraged model such as this tends to rely on steady cash flow to service regular interest payments and make scheduled repayments. Natural resource projects, especially at an early stage, may not be able to guarantee the kinds of cash flow that leveraged-debt providers would normally expect to receive. However, bank debt or project financing could be employed to provide the debt element in a project’s financial structure and that financial structure could also accommodate PE investment.
Benefits of private equity
PE and funds offer certain advantages to the mining sector over other conventional methods of financing, including that PE investors and funds typically invest for three to six years. A longer-term outlook and limited options for an exit mean that PE investors who are comfortable with the cyclical nature of the mining business are viewed as providing “sticky” funding, which is less likely than others to be withdrawn when faced with operational setbacks or delayed returns. The significant capacity of certain PE and other funds puts them in a favourable bargaining position when competing with other potential funding sources. In operating outside of the disclosure regime required of a public company, an early stage operator can work below the radar without the need to make public announcements that alert rivals to its successes.
Seasoned PE investors can also bring additional expertise in methods of streamlining production facilities and securing global customers, which can be of particular value in resource rich developing markets. This expertise, combined with the significant funding capacity of some PE and other funds, has put these funds in a prime position to exploit emerging opportunities in the mining sector as miners struggle to raise capital by traditional means.
PE also has the advantage of being able to develop a project outside of public scrutiny and less focus on a market share price, when compared with a listed company.