Private equity finance

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Published: Tuesday, 23 August 2011

Private equity funds are becoming a familiar presence in the industrial minerals market. John Pfahl examines how PE offers stable, long-term investment to a traditionally cyclical sector

 
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

 

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.

 

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.

 

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.

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

 

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.