Commodity pre-payment agreements originated typically by trading houses, industrial buyers and speciality hedge funds, are essentially just sales contracts, whereby a buyer agrees to purchase a certain quality and quantity of a commodity for a fixed term from a producer in exchange for an up-front payment. Each arrangement is highly customised to reflect the results of the due diligence of the underlying assets, the debtor profile, the relevant jurisdiction (for purposes of the perfection of the security package) and the nature of the relevant commodity. For example, under a customary gold pre-payment agreement, a gold miner is required to deliver a specified quantity of gold or related proceeds at monthly intervals over a specified term and the transaction will normally be structured to gradually increase the quantity delivered to reflect greater production of gold at a developing mine.
Normally, the buyer bears the price risk of the commodity while the seller bears the costs and expenses for the production, transport, refining and delivery of the commodity to the buyer. The commercial negotiations in the commodity prepayment context often involve the setting of minimum and maximum prices of the commodity and these set points may either be documented in the commodity forward purchase agreement or in an ISDA Master Agreement. The buyer assumes the risk that the commodity price may fall below the minimum price, and therefore negotiates a discounted purchase price, while the seller largely assumes the risk that the price may exceed the maximum set price.
From a buyer’s perspective, pre-payment agreements are often shorter term credits that present a significant financial opportunity for the buyer as well as securing supply of a metal direct from a mine. The buyer will assume a senior, secured position and typically expect to receive a comprehensive or all assets security package as well as robust representations and warranties surrounding freedom of collateral from security, effectiveness of concessions and licences as well as other assurances surrounding due diligence issues that will affect the development of the mining asset. If there is a creditworthy parent company, it is not uncommon to see guarantees issued by this entity in favor of the buyer. Additional credit support in the form of these guarantees or promissory notes may enjoy an expedited enforcement proceeding in some jurisdictions and these issues would typically be considered in conjunction with local counsel.
From a seller’s perspective, this financing vehicle may prove advantageous because, unlike an equity offering or a joint venture, it preserves control of the development process because it may avoid or minimize share dilution and outside input into the day-to-day management of operations. Also, pre-payment agreements are typically associated with advantageous accounting treatment (if structured properly the contract will not be accounted for as debt) and they often do not contain the full suite of financial covenants included in traditional financings and it is common to have a grace period in terms of repayment tied to production and the absence of traditional interest payments.
Other funding products in the mining sector
Under a streaming agreement, the “streamer” (eg companies like Silver Wheaton or Franco-Nevada) provides an upfront payment or deposit to a mining company in return for the right to a percentage of future production at a fixed (discounted) price (like a pre-payment arrangement) but unlike a pre-payment agreement the commodity acquired is usually a by-product of production – for example, precious metals which are the by-product of the mining company’s base metal production. This means that the mining company may be able to access further funds secured against its core asset as well – for example by entering into a parallel project financing arrangement. In contrast to pre-payment agreements, streams usually require ongoing payments due on receipt of physical metal and the arrangement are long term and may last for the life of the mine. If the streaming agreement is terminated early due to the mining company’s default, (like a pre-payment agreement) a payment will become due to the streamer. This payment can be based on a net present value calculation of the return the streamer should have obtained from receiving discounted metal had the contract survived for the mine life. Given the long term nature of streaming arrangements, this amount is therefore potentially huge.
The stream agreement (typically governed by Canadian law) itself will generally be less restrictive on the mining company compared to other traditional debt instruments (like project financing), allowing the mining company to retain greater control over the project’s overall operations and flexibility as the company is only obliged to deliver the product to the streamer when it is produced.
In a royalty arrangement the royalty holder (eg Anglo Pacific Group or Royal Gold) will provide an upfront payment to the mining company (similar to a prepayment arrangement) however, rather than receiving a commodity in return, the royalty holder is entitled to share in the future revenue of the mining company’s project which will last for the life of the asset (like a stream arrangement). This future payment will be typically calculated as a percentage of gross revenue (the right to a fixed percentage of gross revenue on the metal sales) or a percentage of the net smelter return (gross revenues less treatment, refining and freight charges – i.e. cash flow that is free from any operating and capital costs or environmental liabilities).
The interest of royalties holders in certain jurisdictions are capable of being registered against the underlying property which gives the royalty holder a priority over other creditors.
In project financing, a loan is provided to the mining company typically by commercial banks or by ECAs or DFIs to fund the development of the mining project and is repaid out of the project’s cash flows once the mine is producing (rather than by delivery of a commodity as with a pre-payment arrangement). These loans are provided on a non- or limited-recourse basis which means in the event of a default, the lender can seize the project only and has no recourse to the balance sheet of the shareholders (or other assets of the company) as would be the case with a corporate loan. In contrast to pre-payment arrangements, project financing can be expensive and difficult to arrange due to extensive documentation requirements.
A pre-export finance (PXF) structure is more closely aligned to a traditional project financing arrangement than pre-payment or royalty financing. Under PXF arrangements, the lender advances funds to the mining company to assist it in meeting its working capital or capital investment requirements. Once the project enters production, the mining company sells its product to an offtaker. Payments from the offtaker in respect of the sale of the product are credited into a specific account over which the lender will typically take security and the amounts credited into the account will be used to repay the loan.
Given the lack of availability of equity and debt financing over recent years, mining companies have had to look for alternative and increasingly creative forms of financing. This has meant that mining projects may have to employ a combination of the financing products described above with creditors under those different products sharing the same security, for example, project finance and streaming arrangements. This has led to increasingly complex intercreditor arrangements to govern what happens if things go wrong (eg voting amongst the creditors), how the various creditors recover their investment by enforcement action and the order in which they are allowed to do this.
Traditionally, voting constructs in intercreditor agreements are based around the size of the respective exposures and the expected returns to each of the creditors (reflecting their position in any capital structure and their risk placing and giving them priority over other creditors). These are made difficult when the returns on a loan investment and a return on a prepaid stream investment are so different. Fundamentally, a stream sees its full value returned over the life of the mine, whereas, the return profile on a project finance loan will never extend so far, and rarely extends beyond a 30 percent reserve tail. In an enforcement scenario, a lender may be able to obtain sufficient value through either a court or bank/ receiver-led asset sale where, for example, the trucks, equipment and other capital assets are sold separately and relatively quickly. This may well be at odds with a stream provider who, based on the above, would have a preference for the project to be sold as a going concern with any buyer assuming all of the obligations under the streaming agreement. The enforcement scenarios are very different and are unlikely to realize value for both sets of creditors.