Rebuilding value in the discovery space with long term strategic capital

By Henry Bonner (hbonner@sprottglobal.com)

Key points: A move towards private equity for early stage mining companies as a sign the market is maturing

Institutional investors and “smart money” groups may be eyeing the mining sector again.

On the phone from London, Pim Kalisvaart of specialist resource investment firm Altus Strategies relays his strong belief that private equity will come to dominate the market over the next decade. He says right now a move is underway with long term investors seeking to get back in to mining and other hard assets. Kalisvaart previously ran Xstrata Ventures, an arm of the $6.6 billion dollar mining giant Glencore Xstrata PLC1 and before that was with the resources team at JP Morgan.

I asked how private equity funds are looking in the natural resource space.

“A number of new PE funds with a mining focus have recently raised capital, at a time when the traditional sources of capital have run dry,” says Kalisvaart. “This move is likely to provide a valuable life line to our industry. That said, this is intelligent, long term and highly selective capital, not all ships will rise.

“The recent downturn has brought into question the traditional funding model for the juniors. Early-stage mining companies used to get financed by short term, speculative investors through the Canadian, Australian and British public markets. These investors are now retreating having suffered significant losses. As inflation bites into their disposable income, risk appetite has decreased and these investors are unlikely to come back any time soon.” Kalisvaart explains.

“There was always the question as to why the mining sector obtained capital from public markets at such an early stage. The true cost of obtaining this capital is now becoming clear; besides broker fees this true cost includes annual listing fees and advisor costs as well as time spent on investor relations by management. To put it differently, it is a significant percentage of the overall budget of many junior companies and equates to a lot of valuable drill holes in a project. In other industries, companies would likely remain private through the early stages and only turn to public markets later in their life to obtain larger amounts of funding and provide an exit for the early stage investors.

“Intriguingly, at a time when the capital markets have run dry, a number of sophisticated long term institutional investors are seeking to participate in a growing recovery in the sentiment towards real assets. Private capital tends to be more patient than the public market investors and less forgiving of management failure. In many cases, private capital is willing to commit for ten years at a time albeit on a structured, draw down basis. Mining is a long term business proposition, with discovery to first pour often taking 10 years or more, making it ideally suited to the timeframes of private equity investors.”

He goes on to add, “Often, resource companies have a high level of technical expertise but less commercial skill. This lack of business acumen in management has resulted in unduly diluting existing shareholders which in turn amplifies downward pressure on the share price. Compounded over the years, this has created a situation where many firms with reasonably good assets, have board and management teams who are increasingly, or exclusively in it for the salary check. When the financial interests of management are not aligned with those of their shareholders it is often a recipe for value destruction. Private equity groups can bring the complementary commercial skills and rigor to the board room and help companies raise money strategically rather than desperately” says Kalisvaart.

He believes that many investors are looking at mining juniors whose projects have at least a pre-feasibility study, which gives a preliminary estimate of the technical requirements to producing from the deposit. There is a natural preference to avoid ‘discovery’ risk in favor of assets where the geological parameters of the deposit are better known. ‘Discovery stage companies require more specialist skills’ to assess the likely technical risks he says.

What kind of partners will participate in these investments?

“There are some larger U.S. institutions making a move into the mining space through an investment in mining focused PE funds. I believe it is the first time this is happening on such a scale. In my view, these large investors are looking for protection from a potentially inflationary environment through real asset exposure. Many managers of these funds will prefer an activist approach to ensuring their money is deployed and mentored actively and effectively.”

So where to invest for the future?

“Geographically, there are two broad categories of mining jurisdictions. In developed regions, we’ve explored and extracted ore from the near surface deposits. With the low hanging fruit gone, we will have to dig deeper or take on more technically challenging deposits in those countries. On the other hand, there are regions with almost an abundance of near-surface and high-grade deposits. Though these deposits appear more attractive geologically, geo-political risk tends to be higher in these regions although in some cases this is just the perception. There is value in both ends of that spectrum.”

Can investors mitigate the political risk of these fringe regions?

“Risk is always a blend. Some assets will have more political and other ‘non-technical’ risks attached to them. First off, investors have to understand what risks they are taking. Once all risks are identified, it is critical to assess the potential rewards as well as how risks may be mitigated in the case of technical, or evolve in the case of political risks. Lastly, everyone having long term ‘skin in the game’ is a key driver to getting this right. ‘Lifestyle companies’ where the asset serves to pay the management a salary without regard to shareholder value have hopefully had their day. Situations where those involved are rewarded alongside shareholders must be the new model for success.

Pim concludes; “Private equity can be the right kind of partner; it reduces funding risks, provides crucial commercial skills, reduces management distraction on tasks that do not add value and ultimately aligns incentives. ”

Pim believes that over the coming few years we are going to witness a transition away from public deals towards deals funded by private equity groups which will drive changes in the industry for the better.

1 http://www.bloomberg.com/quote/GLEN:LN

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