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Private equity – the last bastion of mining finance

By Laura Syrett
Published: Wednesday, 08 May 2013

Direct investment could offer alternative to stocks and hedges, say experts

As the global economy limps through the second quarter of 2013 in the shadow of dispiriting growth forecasts, the news that the mining and financial sectors are continuing their estrangement won’t come as a surprise to anybody in either industry.

 
Fear of falling: wary investors have shied away from backing mining projects through stock exchanges and hedge funds (image: London Stock Exchange, elias_daniel)
The crisis of confidence which all but paralysed capital markets after the financial crash in 2009 has made new project finance for mining difficult to come by via any channel, with hedge funds becoming the latest cash sources to fall short.

The average commodities hedge fund lost 0.8% in the first quarter of 2013, an index compiled by the brokerage firm Newedge has shown. This is on top of a loss of 3.7% across commodity hedge funds in 2012, the biggest decline in over a decade, according to the Newedge Commodity Trading Index.

Collectively, the funds divested more than 20% of their assets last year - a figure which the Financial Times has calculated equates to a withdrawal of around $5bn from the commodities sector.

Combined with jitters on the stock markets, the haemorrhaging of cash from commodity ventures has led the value of many small and junior mining companies to fall by around 70% since 2009, data collected by Bloomberg Industries indicates.

With investor backing at rock bottom levels, Bloomberg estimates that as many as 40% of companies in the junior mining sphere lack sufficient capital to see out the next sixth months.

Even larger mining firms are not immune from the financial famine, Bloomberg has found, with spiralling capital and input costs forcing these companies to put off acquistions in favour of divestment and mothballing of assets.

Private equity

The breakdown in the relationship between the extractive and financial sectors was the subject of a recent meeting in London: Private Equity in the Mining Industry – A Long-Term Partner, or a One Night Stand?, hosted by Bloomberg Industries.

With traditional mining finance in dire straits, delegates heard, the industry is being pressed to consider alternative, unconventional sources of finance, such as private equity.

Bert Koth, director of Denham Capital Management LP, pointed out that unlike most stock exchange or hedge fund transactions, the majority of private equity comes from investors who can commit large sums of money for long periods of time.

 

Far from being a one night stand, Koth said, private equity is by definition a longer-term partnership. This is because private equity investments often demand long holding periods to allow for a distressed company to be turned around, or a liquidity event such as an initial public offering (IPO) or sale.

Private equity consists of investors and funds putting money directly into private companies, rather than through a public exchange. It can also involve investor buyouts of public companies that result in a delisting of public equity.

Capital for private equity is generally raised from retail and institutional investors, and can be used for a range of purposes from general working capital to simply strengthening a balance sheet.

The size of the private equity market has increased steadily since the 1970s due to its effectiveness as a model for delivering high returns before an investment has begun to generate cash-flow, as well as for allowing operational improvements to be made to the company receiving the funds.

A recent example in the industrial minerals industry was the buying of the minority shareholder stake in Greek materials group S&B Minerals by the US private equity firm, Rhone Capital LPin January this year.

The offer for 38.74% of S&B’s share capital was accepted by shareholders, and Rhone Capital issued a statement saying that it intends to delist this portion of the company from the Athens Stock Exchange in the near future.

According to Ken Hoffman, senior metals and mining analyst with Bloomberg Industries, hedge funds are becoming less relevant to mining projects because, rather than buying mines, fund managers can go directly to commodity exchanges for direct exposure to markets.

With hedge-funding drying up, private equity offers an attractive option for the cash-strapped mining sector, since capital for such funds can be made cheaply available on the market at present interest rates.

Hoffman estimated that around $9bn had been raised for mining deals via this route in the last six months, and mooted the possibility that the industry could see its financing shift in this direction, given that leverage from traditional finance looks unlikely to improve in the near-term.

Koth said that although miners often blame the flagging economy for a lack of capital, the dearth of funds available for mining projects has more to do with the fearful investment climate than with prevailing macro-economic conditions.

“Many people have lost their money [in mining investments] over the last five years,” Koth said, adding that it was hardly surprising that people were shy of sinking their capital into the industry.

Despite this, Koth hinted that there was scope for investors to generate returns by investing directly in mining ventures, if they have the ability to pick good projects.

Plugging the gap

Lee Downham, lead partner for Ernst and Young’s transaction advisory service, mining and metals, said that the question of alternative financing lay more with private, or venture capital, rather than private equity.

This is because the kinds of private funding available to the mining sector tend to be more characteristic of venture capital investments, i.e., they account minority stakes, rather than buy-outs; are based on cash alone, rather than a combination of equity and debt; and are available mainly to early-stage companies, rather than mature firms.

“Last year saw a two-tier capital market for the mining sector,” Downham observed, saying that very little had been raised from IPOs, meaning that companies were looking to non-traditional sources such as bonds and mergers and acquisitions to generate cash.

Downham said that while capital raised by private funds and alternative investment sources was on the increase, “it has nowhere near filled the gap left by public finance”.

He added that companies that had turned to the high-yield bond market for cash had found this route to be largely unsuccessful, owing partly to the volatile nature of this market.

Obtaining bank loans, for the most part, has also proved futile, Downham said, with lending at its lowest level since 2009, while loans that were issued were focused on corporate debt, rather than new project financing.

Downham concluded that while private equity investment couldn’t accurately be thought of as a fleeting liaison, based on analyst forecasts, the window of opportunity for private capital investment in mining was destined to be short-lived.

The movement of private funds into mining projects “will last for no more than two to three years”, Downham said, “by which time, we expect major mining firms to be sitting on a strong cash position”.

Internal problems

External economic factors aside, the resource industry is also facing worrying structural challenges that are eroding the financial performance of mining firms, and deterring investors.

Hoffman said that wage increases in the mining industry since 2000, which have been widely pegged as rising by 50%, have translated to a 200% increase in actual wage payments.

This is due to resource deterioration, Hoffman explained – because today’s mines are much less productive than they were 20 years ago, mining companies are having to employ more people over more hours just to achieve economic recovery rates from mineral deposits.

Hoffman also pointed to the rising cost of energy in the mining sector, which is around 125% higher, on average, than prices paid for power a decade and half earlier.

Koth added that a severe skills shortage in the industry was responsible for many of the capex overruns in mining projects.

Capex overruns of 40% are typical in today’s bearish market, he said. “In the bull-market [pre-2009], capex overruns of 70% were not uncommon.”

Taking all of these factors into account, small and junior miners are being urged to reconsider their business strategies and adapt to adverse circumstances that show no sign of abating.

As part of this re-evaluation, Koth said that juniors should look at the cost of being a public company as an efficient use of scarce funds

Koth said that the high capital costs of being a public company – which he estimated as being between $0.5m-$0.8m on average for junior firms – was cash that many companies could ill-afford to lose when incoming capital is limited.

Another drawback of being public company was the amount of time spent on public and investor relations. Around 40-50% of a junior mining company CEO’s time is spent in this way, Koth said, suggesting that this could be better spent advancing the company’s business plan.

He added that the pressure to put out a press release every time there is a significant event relating to asset valuation was not only time-consuming, but also attracted rival prospectors to an area reported to contain rich resources, increasing competition.

“Commercially, it might be better to operate under the radar,” Koth suggested, adding that, looking into a tight credit future, private ownership might be a sensible option for some junior companies.