Over the last two years the mining industry has undergone one of its most radical transformations in recent times. A shortage of capital, highly leveraged balance sheets and volatile commodity prices have forced many mining companies to seek to optimise their portfolios, and divest those assets which they deem non-core.
This strategy, coupled with a continued reluctance of the capital markets to invest in the sector, has resulted in a significant drop in investment activity across this space. This shortage of available finance analysts argue has created an opportunity for less conventional forms of finance to play a greater role in this sector.
Of these the most important alternate source of capital is private equity, which traditionally has proven reluctant to invest in this space. However, the wealth of opportunities and the potential high rates of return has encouraged the emergence of a plethora of funds with a specific focus on this sector.
Whilst industry insiders have met this development with scepticism, the success of these funds in raising capital (currently estimated at over $10 billion and likely to increase further) has meant that it is becoming harder to ignore that they have the potential to play a major role in the industry. Accordingly for many analysts the question is no longer if private equity will play a significant role, but more when and where they will target.
The answer to these questions will likely be determined by how quickly the private equity funds overcome the issues detailed below.
In order to successfully evaluate the viability and profitability of a mining project extensive technical expertise is required across a number of disciplines such as geology and engineering. This experience is integral to deal making in this sector with major companies employing specialist teams to evaluate potential investment opportunities. As traditionally private equity has not had this depth of expertise, it has historically struggled to identify attractive opportunities. In recognition of this weakness many of the funds have embarked on recruitment drives and have recruited heavily from the mining sector.
This is most apparent when comparing the funds with those mining companies which operate across a range of different sectors. To minimise this issue most of the funds have adopted the strategy of initially focusing on a narrow sector of the mining industry.
This policy is likely influenced by the fact that the funds involvement in this sector is very much nascent, and will likely change in the coming years as they develop their portfolios and the depth of their expertise.
Return on investment
One of the most talked about issues that many industry insiders believe that private equity faces in the mining space, is the fact that a mining investment represents a very different type of asset to what a private equity fund has traditionally held.
The predominant differences can be separated into three categories:
Lifecycle of investment
The traditional investment cycle for a private equity fund is normally on average between five to seven years. This provides investors with a set exit plan, and allows the fund to realise a return from its capital within a reasonably short period of time.
By contrast some mining insiders have argued that in order to realise the value of an investment in the mining space, investors are often required to hold the asset for sometimes as long as a decade before the asset can be sold off for an appropriate rate of return.
As a result this theoretically means that a mining investment represents a very different kind of investment for a fund. However, in reality this analysis is over simplistic in its approach as it fails to differentiate between the range of investments available within the mining space. Accordingly whilst an investor investing in an exploration project could potentially have to wait for a decade to realise a return on its investment, the same is not true for other types of investment in this sector.
Two examples that illustrate this are as follows:
- investments in junior miners who already have producing assets but need further investment in areas such as infrastructure (e.g. railway/ port/ power infrastructure); and
- investments in mature assets that are reaching the end of their production cycle and are regarded by many mining companies as non-core.
Dealing first with the former, an analysis of the mergers and acquisitions market over the last five years identifies an increasing trend of junior miners successfully seeking short-medium term investment to either expand their project or finance the construction of associated infrastructure. As these projects are typically already producing they provide an opportunity to invest in an asset where a mining company is often selling only a stake in a project, meaning that the fund will have the benefit of the asset being run for them, and will often be able to exit following the completion of either the infrastructure or the expansion.
Whilst there has been limited investments by private equity funds to date in this type of investment, analysts believe that the level of interest from the funds in this area of the sector is growing rapidly, suggesting that this trend is likely to change over the next couple of years. The region touted as being likely to benefit the most from this in the short to medium term is Africa, with both the level of interest, and the number of deals in this area having increased markedly over the last year.
In terms of the latter, investments in mature assets have proven attractive to private equity funds over the last couple of years, with the majority of investments by funds to date occurring in this space. This is likely because these assets are cheaper, smaller, and represent a way in which the funds can develop a feel for the industry, through investing in an asset which has already been built and developed. In addition the asset will have all of the necessary infrastructure and facilities meaning that the fund is purchasing an asset which offers an immediate rate of return.
Whilst undoubtedly the issue of risk is central to the question of how significant a role the private equity funds will play, it appears to be one which will have less of an impact going forward as the funds develop a greater understanding of the sector, and of how to manage its risks.
Indeed, what will prove interesting over the coming years is how quickly the funds begin to invest in in the undeveloped, unprospected exploration assets, whether independently, or as part of a partnership along the lines of the above.
A major difference between an investment in a typical exploration asset, and an investment in a company in a sector such as the manufacturing industry, is that the former will often provide a more certain and immediate earnings base than the latter. This difference is of course intrinsic to the structure of the mining industry, with each undeveloped asset requiring significant investment over a number of years before it enters production and starts providing a return.
Accordingly this is not so much an insurmountable obstacle, but an issue of developing a financial model which takes this into account. This is of course precisely how the mining companies address the issue, with a key part of any financial model being how many years of production it will take an asset to repay its capital expenditure. As a result this is an issue which is relevant to the whole sector, requiring investors to take a different commercial approach than they would with a more typical investment whose return on investment is traditionally more rapid.
Part of the complication lies in the fact that evaluating a mining asset, and compiling an accurate model requires extensive understanding of the industry, asset, and commodities markets. However the increasing expertise of the funds in evaluating assets, and in understanding these issues, means that this obstacle will be less and less relevant. Its centrality to any decision to invest in a mining investment means that it is likely an issue the funds are already addressing and are comfortable with.
As mining investments are inherently capital intensive and are often based on more assumptions and projections than other types of investments, they are traditionally regarded as being more risky. Whilst this statement is of course contradicted by those assets which are at the peak of their production cycle and therefore carry considerably lower risk, these assets are rarely sold, and if they are, are purchased by either the mining giants or sovereign wealth funds for the reasons discussed below.
As a result a traditional barrier to private equity involvement in this space has been the point that the funds have essentially preferred to invest in enterprises which they deem less risky. This is hardly surprising considering it is estimated that 56% of projects exceed their development budgets.
However the concept of what the funds deem risky is likely to evolve as their understanding of the sector develops. As a result whilst it is unlikely in the short to medium term that we will see private equity financing large risky greenfield projects, it is likely that as their confidence grows the funds will begin to invest in a greater range of investments in this sector.
The reason for this is in part because whilst mining assets are more risky and uncertain than other typical investments, there is often a correlation between risk and potential profit which is hard to ignore.
This of course does not mean that we can expect to see private equity investing in high risk projects, but does suggest that deals focused on low-risk geographies, and on leveraging underperforming assets are examples of risks which will increasingly be taken.
The third issue which is often discussed is that of competition. Unlike the other factors, which are regarded as traditional barriers to the entry of the funds into this space, the issue of competition is both a historic and a current concern for the funds.
The reason for this is that whilst traditionally the funds main competition would have come from the large mining companies, the change of strategy in their approach forced upon them by their investors and the global commodities cycle, has not entirely cleared the field. Government funded companies of energy hungry countries such as China have increasingly demonstrated over the last few years that they are interested in acquiring assets which they deem valuable or strategic to their needs.
The relevance of this to private equity is that these entities have considerably greater financial resources and technical expertise, meaning that there is a danger that the funds could find themselves out bid on certain projects.
However as the funds role in this sector grows it is likely that they will seek to mitigate this issue through raising further equity, debt finance, or through forming partnerships.
As a result the issue of competition in itself cannot be regarded as a barrier to the growth of private equity in this sector, as their actions are unlikely to limit the activities of the funds, but merely illustrates that this is a competitive sector. Indeed one of the key issues to watch over the next couple of years will be how the interaction develops between the mining groups, private equity funds, and sovereign wealth funds.
Point of Entry
The final point to be discussed is the point of entry at which a fund decides to invest in a mining investment. Private equity funds have traditionally shown very little interest in acquiring prospecting licences, or exploration licences, primarily because these projects are risky, capital intensive, and require extensive levels of resource and expertise to develop.
However the shortage of finance is most critical in this sector, with junior miners in particular struggling to raise funds to finance the development of their operations.
As a result whilst private equity is increasingly active in mature and late stage assets, the key issue is whether this involvement will be replicated in early stage assets. Whilst it is unlikely that we will see significant activity in this area of the sector in the short term, the fact that some funds have hired specialist geologists suggests that projects of this sort are increasingly being considered.
When and if this translates to an investment will depend on how comfortable the fund and its investors are with the risks and the projected return on investment. Accordingly this is an area to watch as an investment of this sort will represent a watershed for the funds, and will demonstrate conclusively their emergence as a major player in the industry.
With the number of funds continuing to proliferate, and over $10 billion in cash raised to date, it is not a question of if, but more when and where this capital will be invested.
Indeed, it can be argued that whilst the above factors were historically real barriers to private equity, this is now no longer the case. Indeed, the mining industry itself is not a stationary object in this context, and is itself actively trying to encourage new flows of finance into the sector.
Clearly there is some distance to go, with activity still largely limited to specific types of assets, and to small investments. However considering the amount of capital that has been raised, it is unlikely that the current trend of deals will continue for much longer. Indeed, looking forward it is likely that the best fit for private equity in the short term is the African market.
This is because this market has not only a large number of opportunities for investment, but also suffers from a chronic lack of finance, which is illustrated by the fact that 75% of IPOs in Africa have failed over the last few years.
As a result there are deals to be done, and an increasing number of opportunities on offer, meaning 2015 could prove to be the year when the funds show their hand. Our next briefing on private equity and the mining space will explore this topic further, and will focus in particular on the developing opportunities for the funds in Africa.