Can Juniors borrow instead of raising equity? – Kenton Ralph Toews

The new equity dilutes existing shareholders’ proportional ownership and decreases the value of existing shares. Therefore shareholders and management often prefer to keep a tight share structure, issuing as little new equity as possible.

Low equity prices will exacerbate dilution since more shares are required to come up with the money to meet a company’s capital needs.

To protect current shareholders from dilution and possible decreases in share prices, juniors who can afford it may turn to borrowing money.   And just like some investors have the ability to participate in private placements where they directly fund the company, some investors may also participate in lending money directly to the company.

Originating loans in the junior space is risky and not easily accessible to most investors.  Sprott is probably better known for raising money in the junior sector through private placements, but Sprott is also involved in loaning money to resource companies.

The characteristics of debt can make it an attractive alternative to the equity in stocks. As Rick Rule says “the worst piece of debt on a balance sheet is better than the best piece of equity.” Why does Rick say this?

Well, typically creditors have a higher claim to a company’s assets than a shareholder.  This means that in a bankruptcy, creditors get paid back before stockholders.  This may limit the creditor’s downside relative to common stockholders.

In the United States, it is not always this simple. In US bankruptcy law, the court oversees the liquidation of companies that file for Chapter 11 bankruptcy protection.  The court could also decide to favor the equity holders — or any other group involved — over the debt holders.

A recent example of this the General Motors bankruptcy debacle from 2009.¹

The US Treasury, the union’s retiree benefit trust, and the traditional bondholders had relatively equal claims to the company’s assets, but were treated very differently by the courts overseeing the bankruptcy.  The US Treasury got $0.87 on the dollar for their $16.2 billion in loans.  The union’s retiree benefit trust got about $0.76 on the dollar for the $20 billion they were owed.  In contrast, the bondholders only received around $0.05 on the dollar for their $27.2 billion in GM bonds.

In Federal bankruptcy law, taxes and retirement contributions get paid first. In the case of GM, the US Government stipulated that the Treasury get paid ahead of the bond holders.

To minimize risks related to the debtor’s claim to the borrower’s assets, Sprott avoids lending money to companies in the United States. Companies under the system of British Common Law in countries such as Canada, Australia, New Zealand, and the United Kingdom may be more attractive to lend to if the risk of default is real.  Although foreign countries may present different risks to be aware of, when a bankruptcy occurs in these jurisdictions, creditors have the right to be involved in the management of the assets and their claims to those assets are respected.

This is especially important in lending to junior resource companies because of the risk of default involved with these companies.  The risk comes from the fact that few junior mining companies have any positive cash flow.  This is why it is important to properly value the collateral put up for a loan.  In the worst-case scenario, lenders may need to sell a property or auction off a piece of equipment to recoup their money.

Sprott pays close attention to valuing the collateral of the companies it lends to and typically has a potential suitor in mind should a default occur and assets need to be sold.

Since property or equipment could be challenging to sell off in the event of a bankruptcy, creditors may be at risk of not receiving full payment of interest and principle at the expected dates.  Therefore a proper loan portfolio should be comprised of multiple companies — similar to a proper stock portfolio being comprised of multiple positions to diversify risk.

If the risks above are properly mitigated, then lending to resource companies can be an attractive business, especially in the current market where share prices are weak and companies aren’t eager to issue new shares.  And because of the sector’s constant need for capital with few participants willing to lend, and the higher overall risk profile of companies in the junior resource space, the rates of return from these loans can be significantly higher than dividend yields or other sources of income, which can make them attractive for investors who have the ability to participate in lending and who have a higher tolerance for risk.

Questions? Contact Kenton Ralph Toews.

By Henry Bonner [email protected]