The secrets of junior mining private equity risk managers

Cheryl Brandon, a partner at Waterton Global Resource Management; Dan Wilton, a partner at Pacific Road Capital Management; and David Thomas, managing director of Resource Capital Funds, brought their insight. Anthony Vaccaro, publisher of The Northern Miner, moderated the spirited discussion that shed light on how private equity investments in junior mining work, the widely held fear of private equity among CEOs and a surprising level of interest in junior mining equities by private equity fund investors. What follows is an edited version of that panel discussion.

Anthony Vaccaro: A few years ago, there was a perception that private equity was going to come in and wash away the junior sector’s worries about insufficient capital. Was that perception misplaced?

Dan Wilton: The perception was somewhat misplaced. I think people saw big numbers being raised, $2, $3, $4 billion ($2, $3, $4B) by people like Mick Davis, but that’s very different from what we do. You need to understand our investors to understand how we invest. It’s a different investor base than you would find in a traditional mining resource fund. Our investors tend to be big U.S. pension funds or university endowments—not retail investors. They commit money to us for 10 years, and they’re patient. Unless the fund has a specific mandate to go out and fund exploration—and few of the private equity funds do—there tends to be a bias toward later-stage asset development.

Funds like ours are not investing in a portfolio, they’re looking to buy an asset and grow a company. The pool of traditional mining-focused private equity is smaller than people know. It tends to be focused more on later-stage opportunities because that’s where you can deploy larger amounts of capital. It’s difficult for us to put money out in $1, $2, and $3 million ($1, $2, $3M) increments when you have a $475M fund to invest. When you’re looking to put it into six or seven assets, those numbers get fairly large. And if you’re a $6 or $7M market-cap company and someone offers you $20M, you’d be amazed at the resistance. People don’t want to take the dilution at these levels, but at some point you have to have a supportive partner. It’s a viable strategy, but most companies don’t want to sacrifice the option value.

AV: There is also a perception that private equity firms can sometimes be ruthless. Is that fair?

David Thomas: It’s important to make the distinction between what Cheryl’s, Dan’s and our funds do versus the big private equity generalists, like KKR & Co., The Carlisle Group, and The Blackstone Group. We’re a sector fund, with a “niche-y” investor base, which happens to be the same as Dan and Cheryl’s investor base. Sector funds would be more akin to a venture capital fund. The bad guys, if you will, would be the bigger, leveraged buyout funds. Because of the inherently risky nature of the mining sector, you really don’t want to multiply those risks by layering in financial risk, so Resource Capital Funds (RCF) does not use any leverage when it’s making investments.

AV: What are some of the advantages that mining companies would garner from working with a private equity firm?

Cheryl Brandon: The mining sector in general has been very retail investor-based or institutional resource-focused investment funds, not private equity. As a result, most of the projects are long-dated, meaning long-term capital. That’s one thing that our groups bring to the table—long-term capital. Our fund lives are 10 years. All the funds here have large technical groups internally, so we really understand the risks associated with the underlying projects, and we underwrite as such. When we are putting an investment into a company we say, “OK, if the company needs X and they want to do Y, let’s come up with a fully financed plan to create value, so that when the market turns, not only will the company have a strong, supportive partner, it will also have a project that’s much more advanced.” That’s the way we look at it.

Back to Dan’s point about dilution, a lot of the companies we speak with don’t want to take the dilution at these levels. However, when the commodity cycle turns, having a strong partner and a project that’s further along the development curve will benefit shareholders.

We all do different types of structures and financings—joint ventures, asset purchases, equity investments and structured financing. The advantages are different for each structure.

AV: Dan, what kind of risk profiles are you looking at? How do you distinguish between later-stage projects?

DW: There’s no shortage of risk in this business, so a big part of our due diligence process is about understanding those geological, metallurgical, operating, jurisdictional and financial risks. It’s a risk/return business. When we see a risk that we can mitigate, that becomes part of the funding plan. But our return expectations are higher for something that has risks we can’t control. For example, we have an investment in Kenya, which is a challenging place to do business, so our return expectations are higher than they would be for a gold project outside of Val-d’Or, Quebec, where you don’t have the same inherent risks. Private equity groups have a pretty high tolerance for risk. We’re in a risk-seeking business. We have to take risks to earn upside returns, but I think we have a better understanding of a lot of the risks that mining companies face. We have a portfolio of 12 or 15 investments right now and we would tell you that a lot of people running companies don’t have the full appreciation of (the risks) because they don’t necessarily have the benefit of the experience of a diversified view on a whole range of projects.

DT: An example of this partnership is RCF’s history with TMAC Resources Inc. (TMR:TSE), a junior building the Hope Bay gold mine in Nunavut. TMAC is one of RCF’s larger investments in Canada. BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) discovered Hope Bay in the early 1990s and it passed through different hands before it was acquired by Newmont Mining Corp. (NEM:NYSE) in 2007. TMAC management, the core of the former FNX Mining team (Terry MacGibbon and his crew), approached Newmont about Hope Bay after the senior producer put Hope Bay on care and maintenance in 2012. Newmont sold Hope Bay in exchange for an equity stake in TMAC, which at that point was privately held.

TMAC raised funds through a couple of different private rounds before going public. RCF got involved in the later rounds and put a reasonable amount of cash into TMAC to help it derisk Hope Bay, primarily through drilling. Hope Bay is a high-grade but “nuggety” gold deposit, so a lot of drilling was needed to establish confidence in the resource. A lot of private equity funds will often try to sell down on an IPO, but RCF bought more stock. The TMAC management team attracted a debt component to the financing package to build a gold mine in a tough market. Having RCF there as a strong partner gave the lenders greater confidence.

CB: With a structured-lending investment, we typically don’t take board seats. Essentially, we get an operating report from the company every quarter that says how the company is advancing the project.

Most of the joint ventures we’ve done haven’t been as the operator, so we allow the company to operate the asset and have a management committee, of which we make up a portion and the public company makes up a portion. The annual budget determined at the beginning of the year says: “This is what we’re going to accomplish and this is what we’re going to spend.” We fund a pro rata portion of that budget.

As an equity investor, we recently made a 19.99% equity investment in a public junior with a project in Nevada. We have one board seat on a six-seat board and another on the three-member technical committee. As it relates to corporate decisions, it’s ultimately what’s best for shareholders. All the private equity funds here invest using different structures, which I think is an advantage because we can help shape the investment for what the company needs.

AV: Tell us about accountability and how that works.

DW: In situations where we’re a 25%, 35%, 40% shareholder, a lot of management teams find it quite different managing a company where you have one shareholder who really cares. We like to think that we can bring something to the table, whether it’s best practice, free advice or getting some good technical people in our network to help. One of the single biggest differences between having a diversified shareholder registry and one large shareholder that is really vested in your success, is that with that large shareholder comes a significant degree of accountability.

The reality is management teams should always be accountable to the smallest shareholder, that’s their fiduciary duty. But it takes on a different meaning when that shareholder or a couple of shareholders are 80% of your shareholders. The people who really prosper with private equity see it as positive. It removes a lot of the uncertainty because we generally don’t care about week-to-week. We care about getting good technical work done, de-risking a project and unlocking the fundamental value of those resources. If that means shutting down an operating mine for a period of time if that is the right thing to do, it doesn’t bother us. We like to think it’s a real positive, but there is only a limited subset of people running public companies who see it that way.

AV: How does your group deal with tension when it happens?

DW: It depends on the situation. We have a number of investments where we’re 20% shareholders with a board seat. Frankly, we have found that to be pretty ineffective because you don’t have sufficient influence to execute change. It comes down to boardroom dynamics.

When you’re a majority shareholder, you can speak with a more direct voice. We had one investment where the management team told us they were interested in having a supportive, long-term investor, but the reality was that they weren’t. The choice was to sell the stock or change the management team. It can go in either direction. Generally, if we’re not happy, most of the other shareholders aren’t happy either.

AV: A lot of people here are familiar with Pretium Resources Inc.’s (PVG:TSX; PVG:NYSE) deal with Blackstone Tactical Opportunities and Orion Mine Finance Group. It’s interesting because there’s a debt component, an equity component and a streaming component. Is this an evolution of the private equity investment model?

DT: Private equity funds pride themselves on being flexible in the financing solutions that they offer mining companies. This is a perfect example. These private equity firms worked with Pretium to come up with a comprehensive financing package. Brucejack is still not fully funded, but to attract $540M from two investors in this market is extraordinary. Orion has been doing streaming deals for quite some time but the number of ounces that are covered under this streaming deal is capped. Royalty and streaming companies typically want life-of-mine exposure to give them that optionality. So if you’re Pretium management, that’s pretty attractive because Brucejack contains a lot of ounces. You’re going to see more of these hybrid deals.

One of the things that I will point out, though, is that these deals require a certain level of financial sophistication. If you’re a CEO of a mining company and you are considering doing business with a private equity fund, it’s pretty important that your finance team is the “A” team because there are fairly demanding reporting requirements, and the term sheets can be complex.

AV: Has RCF done any streaming deals?

DT: We have negotiated some royalties as part of bigger financing packages, but we have yet to do a stream. There is nothing that would stop us from doing one, if it made sense. The issue is that streams in the eyes of some of the ratings agencies are treated as debt and that can be problematic for insurers.

AV: Cheryl, let’s look at the investments that Waterton makes. How many companies are you looking at? And what are the metrics that Waterton uses to evaluate companies?

CB: We have a narrow focus. We look primarily at copper or gold projects in stable jurisdictions, and most of those projects have had capital invested previously so they have drilling databases. We know all the projects, whether we’ve looked at them on a desktop due diligence basis or done a deep dive (signed nondisclosure agreements and got material nonpublic information). But for every investment we’ve made—and we’ve made about 14 investments in the past 12 months in our second fund—we’ve looked at about 300. Not all of those didn’t move forward because the project didn’t check out—they often didn’t move forward because a lot of publicly traded mining management teams and boards are still getting comfortable with private equity investors, which is dissimilar to oil and gas. Private equity is in roughly 50% of the oil and gas deals; in mining, that’s not the case.

As it relates to metrics, the way retail and standard institutional investors look at projects is P:NAV or EV:balance or P:cash flow or EV:pound or EV:resource. Everyone values an asset (net asset value), using the underlying metal price. We don’t. We have a downside scenario where we ask what happens if gold goes to $900 per ounce ($900/oz) and how are we going to ensure that our investment is still there at the end of four or five years, so that we can benefit from the next cycle? We also know that gold could get to $1,600/oz. It might not happen tomorrow, but it may happen in 2020, so we ask, what does our investment look like in that time horizon? We actually underwrite with higher commodity prices. We’re OK taking on those risks; we just need to underwrite them appropriately and make sure that there are no fatal flaws.

DT: Years ago RCF hired a corporate social responsibility (CSR) officer to work with its deal teams during due diligence and throughout investment ownership. Our investment in Noront Resources Ltd. (NOT:TSX.V), which is in northern Ontario’s Ring of Fire district, is a good example of where the fund spent a lot of time on sustainability issues, such as project permitting, engagement with First Nations and other stakeholders including environmental non-government organizations, communities and various levels of government.

CB: You would never imagine that the mining industry is as distressed as it is when you meet with investors who allocate to private equity in mining. We raised our fund in early 2014 and had 10 investors who had allocated a total of just over $1B. We had no plans to raise another fund until those investors told us they wanted to double their exposure. So we’re closing another $1.1B next month.

The appetite for exposure to the sector is very high. When investors find the right team they just want to keep writing checks. They don’t want that money back; they want the money out the door. They understand that now is a good time to have exposure to the sector. We’ve had an unbelievable amount of demand from pension funds and endowment funds that are just cold calling us to ask, do you have room in your fund? It’s a completely different environment (versus what is happening in the public markets). There’s no shortage of capital available to us. We just need to be able to successfully allocate that capital to management teams.

AV: Thank you all for your insights.

http://www.theaureport.com/pub/na/the-secrets-of-junior-mining-private-equity-risk-managers

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