As reported in multiple IM articles, there has
been an apparent increase in investment activity by PE in the
industrial minerals sector over the past decade. To many in the
sector, there is confusion about what exactly PE is, whether PE
will continue to invest actively in the sector, where future
investments might materialise, and if overall, PE investment is
a positive or a negative for the industry.
When most people think PE, they
think of leveraged buyout (LBO) type transactions. LBOs are
where PE has its origins, and are investments that involve an
investor taking control of a public or private corporation
(typically through a 100% acquisition). LBOs are partially
financed by debt - the ‘leverage’ in the
transaction - which is assumed and repaid by the company
that is being purchased.
PE funds - the individual
pools of investment capital usually are referred to as
‘funds’ - that target LBOs are typically
generalist (ie. strong financial expertise, but limited
sector-specific knowledge) and seek undervalued or mismanaged
companies where improvements can be made to allow the company
to realise full value on the fund’s exit. However, while
LBO transactions are still an important part of the PE space,
the term ‘private equity’ now covers a much more
diverse range of investment philosophies.
Beyond LBOs, PE funds utilise
investment styles including non-leveraged buyouts, mezzanine
finance and minority equity investments in private or public
companies. This may seem contrary to the ‘private’ in
PE. PE funds have also broadened away from the generalist
approach to specialise in specific sectors (eg. natural
resources or real estate) where the fund’s in-house
expertise, and all of its investments, are in a targeted
sector.
Because of the sector-specific
expertise within these funds and no requirement to use debt in
their investments, they are able to more successfully reach for
investments in earlier stage companies (ie. pre-production
companies without positive cash flow); similar to how venture
capital funds operate.
Even with the diverse nature of
investment styles among PE funds, there are some key
characteristics most PE investments hold in common. PE funds
are long-term, long-only (ie. no short sales) investors with
average hold periods ranging four to five years or more. PE
investments are also large, relative to the overall size of the
funds, which provides an ownership level high enough for a fund
to have influence with the company.
With the influence PE funds are
able to achieve through their level of ownership, they are
typically active investors, often taking board level
representation and working closely with senior management. PE
funds also go through a more intensive due diligence process
than the average investor, taking between a few weeks to a few
months to complete.
Due to the generally high level of
ownership a PE fund holds, and investments often being in
private companies, PE funds typically utilise two primary
strategies to realise the value of their investments. The most
common strategy is through an initial public offering (IPO)
where the company is listed onto a public exchange. A second
common strategy is through a trade sale to a third party. With
industrial minerals, where public markets may not provide
acceptable value to the less ‘hot’ commodities, a
trade sale is often the most desirable strategy.
Figure 1: Global PE capital raised (by fund type)
Source: Bain & Co. Inc., 2011
Figure 2: Global private equity dry powder
Source: Ibid
PE structure
Aside from the few investment characteristics that PE funds
have in common, what really groups PE together is the structure
of the funds. PE funds utilise a closed-end fund with a fixed
investment time period.
A closed-end fund is one where the
capital raised is capped at a certain amount (ie. new
investment capital is not accepted after the initial
subscription period). The standard fund life is 10 years and
the investment period is typically five years, allowing funds
to be highly selective when investing capital.
When a PE fund is first raised, its
investors (termed limited partners as their only liability to
the fund is their invested capital) commit a fixed proportion
of the overall fund capital up front, and as investments are
made, the limited partners contribute their allocated
proportion of capital for each investment.
Limited partners are not able to
withdraw money from the PE fund but, with some exceptions, can
resell their interest in the fund to other investors. As
investments are exited, the proceeds from the divestment are
paid out as redemptions (ie. capital is not reinvested). Due to
the highly illiquid nature of investing in a PE fund, the
limited partners are typically long-term, stable holders (eg.
university endowment funds, pensions, etc.).
Each fund is regulated by its
partnership agreement. The partnership agreement lays out the
PE fund’s investment guidelines, so that its limited
partners will know how and where their money will be invested.
The fund is overseen by the investment manager, which is
composed of a group of investment professionals that execute
and manage all investments. The investment manager also invests
alongside the limited partners through a general partner, which
holds all the liabilities of the fund.
The investment professionals that
work for the investment manager receive their primary
remuneration from a fixed proportion of all profits that exceed
a baseline rate of return. This, combined with their own
investment into the fund, provides a strong incentive for the
PE management group to successfully execute on its investments.
What that means is that, both in terms of seeking investment
opportunities and in working with companies in a board advisory
role, PE groups are always seeking to maximise the value of
their portfolio companies, with a long-term view.
Industrial minerals: a new interest area
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Talison Minerals’ Greenbushes mine in Australia.
The Perth-based spodumene miner is owned by Resource
Capital Funds.
Talison Minerals Pty Ltd
|
PE typically invests in all types of businesses and industries
in the global economy so it is not surprising that PE funds
have been active in the industrial mineral sector. However, as
previously noted, there has been an apparent increase in the
level of PE activity in the industrial minerals sector over the
past decade. This is likely attributable to some combination of
these three primary factors:
1) The increased amount of
capital under management by PE funds. As shown in
Figure 1, capital raised by PE funds has increased from around
$33bn in 1995 to $228bn in 2010 (with a peak of $666bn in
2008). Although there has been volatility in capital raised
over this time period, there has been a strong trend
upward.
Even with the volatility in the
capital raised, the total ‘dry powder’ (ie. capital
available for investment) has steadily increased over the past
decade (Figure 2). Going forward, even with the
significant decrease in capital raised in 2009 and 2010, due to
the global financial crisis, much of the capital raised prior
to the global financial crisis is still available for
investment. In 2010, committed capital not invested was $964bn
and still close to the all-time high of $1.07 trillion in 2008
(Figure 2) which will continue to support strong PE activity
for a number of years to come.
2) The rise of natural
resource-focused funds, particularly mining. Prior to
the late 1990s, there were no PE funds that specifically
targeted the mining industry. Since that time, starting with
Resource Capital Funds (RCF) in 1998, a handful of
mining-focused PE funds have become active and the size of
these funds has continued to grow over time.
These funds are more likely to get
involved in earlier stage (ie. pre-production) assets and more
difficult to understand commodities than the generalist funds,
given the in-house expertise associated with the focused funds.
Mining-focused funds have generally been very successful to
date, averaging a 38% net internal rate of return (IRR) since
1998 versus an 18% IRR on the benchmark MSCI World Metals and
Mining index over the same time period1. Given the
success of the mining-focused funds, it is likely that they
will continue to grow in size and importance to the sector over
the foreseeable future.
3) The 6-7 year-long bull
market in natural resources. This is driven by
increasing demand by the BRIC countries, which has provided
excellent returns to the sector. These strong returns in the
natural resource sector have greatly increased investor
attention to natural resources which has subsequently increased
the number of generalist PE funds that have targeted the
sector.
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Installation of a rotary
cooler at Queensland Magnesia’s plant in
Rockhampton, Queensland, Australia. QMAG is currently
owned by Resource Capital Funds.
Queensland Magnesia Pty Ltd
|
As far as investment in the mining and natural resources sector
goes, industrial minerals companies are especially attractive.
First, they generally have long-life assets that have
established, long-term cash flow. This is important, especially
for generalist and leveraged buyout funds, because steady cash
flow is required to repay debt and an established, long-life
asset can be easier to evaluate for a generalist that has
strong financial expertise but limited-to-no mining expertise.
In these instances, the mining and processing components of the
operation have already been significantly de-risked, and the
business side of the operation Ð which a generalist has
stronger expertise in - becomes a much more important
aspect to value creation in the company.
Second, there are assets with
dominant market positions (ie. tier one assets) that are still
available in smaller companies, unlike most other sectors of
the mining industry.
Finally, the development capital
associated with most industrial minerals assets is still within
a reasonable range for a company backed by a typical PE fund.
This is more important to the targeted funds as a generalist
fund rarely would invest in a pre-production stage project.
These mining-focused funds are currently in the billion dollar
size range and typically target companies that are in the tens
to hundreds of millions in size. With companies this size,
taking on development projects of multiple billions of dollars,
common in the bulk and base metal commodities, is very
difficult.
Why should IM companies be interested in
PE?
As discussed above, PE funds are already active in the
industrial minerals space and seem to be on a trend to increase
that activity level. In most cases, for a PE fund to make an
investment, the company needs to want the fund’s
involvement and will need to cooperate with the fund during the
due diligence process. The question then becomes: “Why
would a company want PE investment?” The answer is that
there are many advantages to an investment by a PE fund that
should help sway a company to go that route, and four of the
more significant strengths of a PE fund follow.
The first strength is the patience
and commitment a PE fund investment brings. Due to the
structure of PE funds, when an investment is exited, the money
is returned to the PE fund’s investors. This means there
are few instances where that money can be reinvested.
Therefore, a PE fund has long hold periods and strong incentive
to stick with its original investments to realise maximum
returns.
This can be critical in mining
where development timelines and the associated realisation of
value on some assets can take several years and may involve
long-term marketing strategies that would not be palatable to
public markets where quarterly targets must be satisfied. This
also motivates the PE fund to support the investment, and thus
the company, with further capital if necessary, especially
during difficult times.
In comparison, public equity
markets may sell and be unavailable to provide additional
capital during difficult economic periods. The backstop of
additional funds available to a management team helps provide a
more competitive environment when raising additional equity.
This minimises the amount of time required for raising funds
and allows it to focus on the development or operation of the
asset(s).
The second strength is the
expertise that a PE fund can bring to the table. PE funds often
take board representation in their investments and provide
active management support. Investment professionals from PE
funds that participate on boards and with management of
portfolio companies generally bring a wealth of business,
financial, and especially with industry-specific funds,
industry-specific expertise.
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Working on wollastonite: producer NYCO Minerals Inc.
was acquired by Resource Capital Funds in 2007.
Pictured is NYCO’s Lewis mine in Essex County, New
York, USA NYCO
Minerals Inc.
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This level of expertise provides strength to a board and
significant corporate-level horsepower that can help with
general strategy, raising or restructuring debt, initial public
offerings, corporate development and sales and marketing. This
can be especially beneficial to industrial minerals companies
where existing company expertise is often more on the resource
and operations side of the business.
The third strength is the magnitude
of a PE investment. PE funds are typically very active with
management on their investments and thus, given the time
commitment each investment demands, must keep the number of
investments relatively small compared to a hedge fund or mutual
fund. Because of this, the average investment is of a large
magnitude. This benefits companies that are looking to raise
additional capital or owners looking for an exit. It can save
significant time and costs associated with an IPO, or for
companies that are already public, provide capital from a
single investor versus having to seek out numerous smaller
investors.
Finally, for a public company where
the equity markets could potentially discount its value due to
a lack of faith in the project or management, investment by a
PE fund can bring additional validation. PE typically performs
very thorough due diligence, suggesting a company can withstand
intense scrutiny. PE - and especially sector-specific
PE - is often considered ‘smart money’, with
investors willing to follow a fund simply because they trust in
its investment ability.
Despite the many advantages an
investment or purchase by a PE fund provides to a company and
its existing investors, PE has developed a poor reputation with
some people. This largely stems from instances where companies
were overloaded with debt, whether through a leveraged buyout
transaction or through inappropriate development of the
business, hence causing a company to fail.
In the instances where companies
have failed under too heavy a debt load, the PE funds have
often misjudged market trends or debt capacity. While the
possibility of an industrial minerals corporation failing under
the control of a PE fund is real, especially with the
volatility in the end markets, this risk is generally limited
to instances in which significant levels of debt are used in an
acquisition.
Mining-focused funds have so far
tended to avoid relying on large amounts of debt in
acquisitions, while generalist funds seem more likely to do
this. If a significant amount of debt is to be part of an
acquisition, the risk can be mitigated through a careful
evaluation of the PE fund with which a deal is proposed (eg.
what is the fund’s track record and reputation) as well as
having experienced advisors representing the company.
Future PE investments
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Talc
transformation: world number two producer,
Finland’s Mondo Minerals BV, was sold to Advent
International in 2011.
Mondo Minerals BV
|
With the continuing strength of the markets for commodities
driven by the rise of the developing world, coupled with the
growth in the size of funds under management by PE, it is
inevitable that there will continue to be PE deals in the
industrial mineral space. When trying to forecast which
industrial minerals might be targeted, however, the future is
less clear.
To date, there has not been a
concentration of PE activity within any one industrial mineral
sector. PE investments in industrial minerals have been highly
scattered with some of the higher profile investments targeting
bauxite, diatomaceous earth, lithium, magnesia, rare earths,
potash, refractories, silica, talc, tantalum and
wollastonite.
Some of these commodities would be
considered exciting, high-growth sectors with significant
public market exposure (eg. potash, lithium and rare earths),
but many are of little interest to the general public and are
far from being considered the next big commodity. The primary
reason for this is that PE funds typically look for a number of
company- and project-specific attributes to justify an
investment and few companies within any one commodity group
meet these requirements. For this same reason, going forward,
PE funds will likely continue to spread their investments
throughout the industrial minerals industry.
Although it is difficult to say
which specific industrial mineral will be the focus of the next
PE investment, concentrating on the primary attributes that PE
would look for in a company or project when making an
investment can help narrow the list of potential targets:
Valuation: When a PE fund evaluates a company,
valuation is one of the most important factors it will look at.
To start with, the valuation of a company has to be of a level
where a PE fund can model a strong return based on long-term
assumptions. In addition, the level of risk associated with the
investment must be justified by the return potential for the
company or project. Therefore, earlier-stage projects that are
not yet in production and/or do not yet have established
markets (see below for more detail) would necessitate a higher
return (and better entry valuation) than a project that is in
production and has been significantly de-risked.
As for the list of recent PE
investments in the industrial minerals space, one of the
reasons there are few investments into commodities that would
be considered ‘hot’ in the general equity markets is
that these commodities have a tendency to be bid up in price
beyond the point that PE can show an acceptable return on
investment relative to risk.
Asset quality: For many of the industrial minerals,
especially those with only a handful of companies supplying the
majority of global production, the best of class assets with
the most dominant position are the most desirable. Small,
periphery suppliers that are price takers and at the upper end
of the cost curve are of limited interest as a PE-type
investment, since they generally have limited upside due to the
inability to expand market share or positively influence
prices. Further exploration upside is always possible to
increase an asset’s quality, but unless the exploration
upside is compelling it is generally not a risk that would be
acceptable to a PE fund.
Potential for growth: Growth of the business is vital
for any investment since a PE fund needs to be able to realise
a significant increase in the equity value of its portfolio
companies. Growth could come from any number of sources,
including production start up, production increases through
expansion or development of new assets, growth in market demand
for existing products driving up prices, downstream
integration, etc.
Established markets: Having established markets for a
company’s end product significantly de-risks a project.
Unlike exchange-traded metals for which there is no real
marketing risk (eg. an ounce of gold from a porphyry deposit in
Chile is no different than an ounce of gold from a placer
deposit in the Yukon), industrial minerals bring many
additional risks into play with any project that is in the
pre-production stages or attempting to expand through the
development of new products:
-
Available customers without long-term contracts to other
operations;
-
Ability to meet end user specifications;
-
Transportation costs to the end market (and capital
associated with developing the transportation network);
-
Performance relative to substitute minerals;
-
Requirement for a new technology to be accepted to
generate demand for the product.
Existing cash
flow: This is less important for a mining-focused fund
that is willing to take development risk, but much more
important for a generalist fund without industry expertise and
critical if a fund is planning to use debt to finance an
acquisition, as cash flow is necessary to service the debt.
Existing cash flow can also provide a strong basis for
valuation of a company.
While these investment attributes
are not a comprehensive list of what interests a PE fund and
certainly not absolute requirements for investment, they do
provide an idea of the type of company/project attractive to PE
funds. Mining-focused funds are still the most likely to be
active in this space and the most likely to reach further
upstream to pure mining companies and pre-production assets.
Continued interest from more general funds is also a strong
likelihood. Industrial mineral companies that are looking to
raise capital or sell out entirely might consider PE for its
benefits as partner or owner as it provides a competitive
alternative to other options.
Contributor: John Pfahl, associate, Resource Capital
Funds (RCF). Mr Pfahl joined RCF in 2008, and has worked in and
around the mining industry for more than 10 years. He holds a
BSc in Civil Engineering and a MSc in Mining Engineering from
the Colorado School of Mines
Spotlight on Resource Capital Funds
Founded in 1998, Resource Capital Funds (‘RCF’ or the
‘Funds’) are private equity funds with mandates to
make investments exclusively in the mining sector across a
diversified range of mineral commodities and geographic
regions. The Funds employ a range of investment styles and have
significant discretion to structure transactions to reflect the
risks and opportunities associated with each individual
investment.
Since inception, Resource Capital
Funds have supported approximately 95 mining companies (and
several mining-services companies) involving projects located
in 34 countries and relating to 26 commodities. Included in
past and current portfolios are investments in 15 industrial
minerals companies covering 11 different minerals. The
Funds’ principal office is in Denver, USA, with additional
offices in Perth, Australia; New York (Long Island), USA; and
Toronto, Canada.