In some ways private equity (PE) houses are corporate geologists, using specialist knowledge to identify opportunities that are not generally obvious and extracting value from them. They are often at their best when mainstream investors dismiss an industry or sector as not worth investing in due to perceived high risk or low returns.
Mining fits that bill right now. Especially, but not exclusively, in emerging markets, where the industry is vast but fragmented on the one hand, while doing business generally, while still complex, is often easier than is perceived.
The past few years have seen radical changes in the industry after the long boom referred to as the commodities super-cycle came to an end. In 2015 we saw the oil price halve, coal prices slump and most commodities decline. Gold, which has stabilised in recent months, and certain rare earth elements are notable exceptions.
But price decreases and cost pressures have resulted in much of the mining industry struggling for survival, trying to adapt to a very different landscape after many easy years. Mining, like any other industry, is defined by its ability to cope with economic shocks, technological change and macro factors it cannot control, as much as it is by growth numbers in good years.
Now, as a number of major mine shut-downs and downsizings continue, an opportunity exists for junior miners to unlock hidden potential by applying efficiencies and specialist managerial skills to a sector inevitably bloated by the good times.
Whether or not they will be able to seize this opportunity will rest on one thing: their ability to access funding.
With equity markets difficult for miners, while conventional investors look to other sectors, the lack of available finance has created a gap for new players to take a larger role in the sector.
Changing the risk/reward equation
Private equity should be top of the list. PE can bring not only funding but also managerial expertise. There are numerous opportunities for PE investors, given the void left by the public markets. Traditionally, they have been reluctant to invest in this space, either because the mining giants were reluctant to part with quality assets, or the simple fact that during a long boom no-one thinks their assets are over-valued, so even if someone does want to sell, pricing can be difficult and expectations unrealistic.
This made for high risks under the private equity model without an obvious upside to justify the risk. As such, PE firms chose in the past not to invest to any great extent in the mining sector, exacerbated by a lack of technical knowledge of mining and the fact that public markets acted as a sufficient source of capital, even for junior miners.
However, several factors make the mining industry as it currently stands ripe for PE investment. PE investors often find the greatest opportunities and returns in sectors seen as unpopular or troubled. They have a mandate to buy and hold a business, to introduce efficiencies and handle volatility along the way.
This makes them, in theory, able to cope with the capital-intensive nature of the mining business, manage the long development cycle and patiently wait for the return on their investment, if the project is the right one.
Change is now apparent. The assessment by PE firms of risks associated with mining projects has evolved, as some have developed better technical and commercial capability to evaluate mining projects, as well as a better understanding of the sector.
This, coupled with the fact that valuations of mining assets have become more realistic and the availability of high quality mining assets in the market has increased as global miners divest assets and refocus their portfolios on core business, holds the potential for high return on mining investments, attracting PE funds to the sector. But buying an asset such as a mine is different to buying a conventional operating business. PE firms partnering with junior miners make for an ideal combination to extract maximum value from opportunities that arise from divestments or where junior miners are already in possession of valuable assets but lack either the funding or specialist management expertise to realise value with commodity prices where they are.
Some US$2 trillion is invested worldwide by private equity funds every year. Inevitably a portion of that is destined for junior mining companies in 2016. But how much and to which miners?
This is not a one-way street. The mining industry is quickly adapting and actively trying to encourage new flows of finance into the sector, but junior miners need to put as much effort into understanding new potential investors and their business models as the PE houses have put into increasing their technical knowledge. For those junior miners that do their homework and have quality assets, PE investment is now a serious consideration.
A new, collaborative investment approach required
PE firms focus on the bottom-line and often approach investments hands-on to maximize returns. Generally, firms will take a seat on the board of their portfolio companies to protect their investment. This high level of involvement not only includes rigorous capital spending assessments and improvements in governance practices, but they are also often able to offer unexpected added value by tapping into resources and services offered by other companies in their own portfolios of companies. Their involvement allows management teams to focus on deliverables, achieving operational optimisation and reducing costs, which in turn improves the return on investment. They also take a keen interest in retaining key staff through lock-in periods and incentives, and deploy leverage strategically.
Again, this is a two-way street. For example, even listed junior miners are used to a high level of autonomy and will have to learn that working with PE investors is very different from investor relations with many small shareholders, but will be extremely rewarding professionally and financially if embraced.
Apart from providing capital to invest in the business, PE firms may also offer:
- An improved business plan
- Enhanced operational expertise to better support management and help solve problems
- Enhanced corporate governance, financial reporting and transparency
- Assistance with ensuring acceptable returns are made
- Assistance in identifying acquisitions
- Access to the firm's network of contacts and experts
- A more diversified and holistic view on company risks, based on their experience of a broader range of projects and industries.
The long haul and why it matters
It's a truism that investing in emerging markets requires a long-term approach. Most of the projects in the mining sector take time, requiring long-term investment capital. The future-focused objectives of PE investors are well suited to deliver on this requirement. Particularly after the global credit crisis, which taught many talented individuals in private equity how to manage an asset over a long period of perhaps 6-8 years, through the economic cycle. Other investors, who are more focused on quarterly results, may not be willing to wait through the longer-term industry related challenges or the macro cycle to see a return on their investment.
PE firms approach projects differently, working with a fully-financed plan to create value so that when the market turns, the firm will be in a strong position, with a quality asset run by a good team and, where a project is still in development, likely much more advanced than without their involvement.
They focus on mitigating project risk, unlocking the fundamental value of the resources in question and laying a good technical foundation that can be stress-tested and easily understood by the market.
This approach presents a perfect opportunity for junior miners to expand their footprint at every level of the mining asset cycle, from early stage exploration projects to undertaking capital expansion on existing producing assets, or even acquiring mature assets at the bottom of the cycle.
Securing PE funding for the long-term enables the junior miner to balance out short-term risk of market volatility and to take the asset up the value curve through a systematic and structured development and implementation plan, without the fear of funding shortfalls.
Of course, private equity is not a panacea. It is a sector made up of many different firms, not a product you buy "off the shelf". There has to be a good fit between a PE firm and a junior miner in terms of shared goals and ability to work together, as well as a genuine opportunity.
Understanding risk and getting in at the beginning
PE firms understand that to earn the positive returns their own investors require, they need to take risks. The concept of what a PE firm deems risky will vary from one to another, and will change as their knowledge of the mining sector develops, which may result in a more robust investment approach in mining opportunities.
While traditionally PE firms showed very little interest in investing in early stage mining projects, primarily because these projects are seen as the riskiest, most capital intensive and require extensive levels of resource and expertise to develop, as their understanding deepens, PE firms are starting to become more comfortable with the nature of these risks and better able to assess potential returns on investment in these early stage projects.
Unexpected arbitrage opportunities
The icing on the cake in some markets is that governments are actively trying to introduce more competition into the mining sector and welcome new investors.
Taking just one example: South Africa. The South African government is currently seeking to destroy the concentration of mining rights in the hands of only a few major mining companies. The knock-on effect is that inevitably the exploration activities of junior mining companies will increase as they are granted more prospecting rights.
But the timing is unfortunate with commodity prices where they are and conventional mining finance hard to come by. It is also a potential opportunity to secure valuable rights that are in a forced sale situation at attractive prices. That is why investment from PE firms will be vital to junior mining companies who are struggling to raise funds to finance the development of exploration projects. Meanwhile, for PE firms there is a potential win-win scenario if the two sectors collaborate effectively
While PE firms have become more active in late-stage assets, the key issue is whether involvement will grow to include early stage assets as well. The fact that some PE funds have hired specialist geologists suggests that projects of this sort are increasingly being considered. Investment by PE firms at this level of the mining sector will significantly enhance the role played by junior mining companies, providing a potential lifeline to an ailing industry and opening a new sector to cash-rich PE funds seeking opportunities.
Aligned objectives – why the time is now
PE offers a blend of capital and management expertise that is a good fit for emerging markets, particularly for junior miners who may be better placed in the current climate to seize opportunities in the industry resulting from the radical optimisation of asset portfolios by many of the larger miners.
As PE firms adjust their risk perspective on investment in the mining sector, the objectives of PE firms and junior mining companies seem clearly aligned. The availability of PE funds to junior miners will provide a much needed injection into the industry and will go a long way towards creating sustainability in the sector even though the commodity down-cycle and macro-economic pressures may still continue.