Finally, the funding crisis affecting the junior mining sector worldwide has arrived in Australia.
While the mood and markets in Australia remained fairly upbeat, the atmosphere in Vancouver and Toronto has been depressed for nearly a year.
That is until the realization that China’s growth rates, while high by all standards, would be significantly lower going forward.
As the rest of the world was reeling from the GFC and its consequences, Australia’s economy had been cushioned by China’s massive RMB4 trillion (US$586 billion) stimulus package announced in November 2008.
This held iron ore and coal prices at high levels and bolstered the equity story for many Australian mining juniors. Yet now, with the Chinese growth outlook more subdued the optimism has vanished.
However, the moderated growth outlook in China and a debt crisis in the developed world are not the only reasons why the junior mining markets have dried up. There are two other important forces at work here:
- A crisis of confidence in the junior mining sector: Caused by the over-promotion of junior mining stocks by bankers and management teams, this has led to unrealistic expectations in investors’ minds. As these expectations were not fulfilled and investors suffered financially, their willingness to risk further capital diminished to a trickle. 75 percent of mining IPOs over last five years are trading below their issue price and investors have lost on average of 30 percent of their money in mining IPOs over last that same time. Additionally, IPOs in 2010 and 2011 are trading more than 50 percent below their listing price.
- A generational change in the junior mining investor base: A significant number of the high net wealth retail investors who constituted a significant part of the early stage investor pool have retired from investing. It is unclear who is going to provide the replacement capital. Younger generations have less money (partly due to the introduction of superannuation) and do not have the skills and experience to genuinely evaluate the risks of investing in the entrepreneurial mining space. Over many years, the so-called commodities experts have forecasted commodity prices that do not reflect the views of the markets. As shown below, brokers and banks have consistently provided forecasts which are either too low, in the case of gold, or too high, in the case of nickel.
Apart from inaccurate forecasting of commodity prices, the junior mining sector has a long track record of not delivering on its promises and of providing (whether intentionally or not) misleading information to investors on occasion. Examples of this include:
- Capex: The average capex overrun in the mining industry over the last two years is 56 percent. It is not uncommon for capex overruns to be in excess of 100 percent when markets were running and input factor inflation was strong.
These capex overruns occur after the successful completion of bankable feasibility studies that typically state a 10 percent margin of error.
Anecdotally, in West Australia, there was one mining project that came in on budget during the last eight years.
Either the bankable feasibility studies are misstating the capex or the execution of the mining projects is flawed.
While there might be a bias or pressure to report unrealistically low capex numbers in a BFS to demonstrate attractive returns for fund raising purposes, the issue mostly lies in execution. There simply aren’t enough top teams available to execute the large number of mining projects currently under development. In Australia, for example, one could argue that most or all of the top engineering teams are tied up with LNG projects or mining majors.
Therefore other mining projects are forced to make do with teams that are available. It is no surprise that junior mining stocks with high capex intensity are particularly badly hit. A capex overrun of more than 50 percent can substantially wipe out equity returns.
- Opex: Investor presentations often proudly point to the C1 (cash) cost curve positions of their projects. The C1 opex however isn’t a reliable guidance to the money a project makes. One has to add G&A, maintenance capex, amortization (since over time, equipment has to be replaced) to calculate all-in costs. Often, much less cash flow is generated than suggested by the C1 opex numbers. Gold developers recently have come under strong criticism for opaque cost reporting.
Markets can, and do, turn around very quickly, but there are no positive indications that could dispel the negative sentiment in the junior mining markets. It should not be a surprise that there is a crisis in the funding markets.
The Pain to come
It remains to be seen whether this funding crisis is a prolonged trough from which the sector will recover or whether a paradigm shift in the funding of entrepreneurship in mining is under way.
In both cases, the funding constraints are likely to lead to a significant weeding out of less value creative management teams and boards, as well as of less economically attractive projects.
It is also likely to cause significant pain in the services sector around mining, from contractors, bankers and others.
The junior mining market place is built upon junior miners regularly raising capital, which results in large number of financial intermediaries, consultants, etc… As junior miners dwindle significantly and the way in which they raise capital shifts, their marketplace will also change materially.
There are a significant number of junior miners with less than 12 months worth of cash, at current burn rates.
This doesn’t mean that within a year half of all junior miners will be insolvent, as burn rates can be cut dramatically if need be.
Salaries to C-suites can be stopped and a company could be run from somebody’s house. However, a significant number of juniors are likely to collapse financially, be forced into mergers out of necessity or founding shareholders may have to inject regret capital to keep companies alive while others will have to shed assets for very limited compensation.
In the long term, those companies that survive this trough will flourish, since the current funding crisis will cut off funding for many good projects, thus curtailing the replenishing of project pipelines.
The grim outlook in the equity markets is not reflected in the markets of the underlying metals. Several key commodities are trading in contango (suggesting supply squeeze), while price forecasts used by equity and market research are backwardated.
Unfortunately the metals markets’ slightly bullish sentiment does not translate into higher share prices because investors have lost confidence that the junior mining sector will create shareholder value in the entrepreneurial journey from exploration to producer.
Another sign of the times are the low price to book multiples found in the junior mining sector. For example, a P/B multiple of 0.7 means that a company trades at a 30 percent discount to the capital invested to date.
However the actual financial loss is greater than 30 percent, as the P/B multiples are calculated on the amounts capitalized on the balance sheet.
The multiples do not take into account cash that has been expensed through the P&L and not capitalised. Thus if a company trades at P/B-multiple of 0.7, it means that the stock’s value reflects an amount that is much less than 70 percent of the money spent.
With the public markets barely providing the requested funding, can private capital fill the void? There are three main sources of private capital:
- Private equity
- Offtakers and traders
- Large mining houses (JVs, partnerships)
The author of this article estimates that there is approximately $10-15bn of genuine private equity capital available for the entrepreneurial mining sector.
This is equivalent to the total money invested in public equity raises in 2012, which was the weakest year for listings since the mining boom started in 2005.
Thus, private equity capital will certainly not suffice in replacing the public markets. When a private equity fund backs a management team or a project, it typically commits a significant amount of capital.
The due diligence into people and projects is much more rigorous than in the public markets, given the larger capital amount. Private equity funding is only available for leading teams and projects.
Private equity in metals and mining has, so far, been the domain of a very limited number of sector specialized firms that have an established track record of investing and successfully managing the extreme risks of the entrepreneurial mining space.
Recently, several large generalist private equity funds, family offices and sovereign wealth entities have shown interest in investing in the early stage entrepreneurial mining space, however their long term commitment to the sector will be tested, given the risk profiles involved.
It remains to be seen if private equity will become a source of funding as important to the entrepreneurial mining sector, as it is to the entrepreneurial oil and gas sector in the US, where it has become a primary source of funding. The current capital market crisis might well be the catalyst for such a paradigm shift in the way in which companies are funded.
The advantages of private equity over the public markets are:
- Management teams spend minimal time on investor relations and corporate matters vs. the public companies. C-suites in listed companies often spend more than 50 percent of their time on IR. This time could be better utilized creating value and moving the business forward.
- No requirement to disclose sensitive information to competitors. Public companies have to disclose material developments through press releases. As a result, further consolidation of land positions becomes more expensive once positive drill results have been released as rival prospectors are attracted into the area. In certain circumstances, detailed disclosure of successful projects can be outright dangerous since it attracts unwanted attention (e.g. Intrepid Mining Limited, Churchill Mining PLC).
- Management has vastly superior economic incentives in a private equity funded venture than in the public markets. A typical public company CEO has 1 to 1.5 percent of the equity and is at risk of dilution, while in a PE-funded venture, the economic ownership of management is much higher and typically protected from dilution.
- Pursuing the long term optimal business plan versus serving the short term-ism of the market
- Avoiding the cost of being public (listing fees, corporate and compliance costs, fees for professional non exec directors etc) during times of scarce capital. As one CEO recently said: “For me, the annual $500k-600k I have to spend on being public is 4,000 meters less drilling I can carry out.”
Private equity is the only available source of private capital that is genuinely aligned with the entrepreneur’s financial objectives, namely to maximize the value of the business and then to monetize it, at as high a valuation as possible.
Both offtaker funding and partnerships with large mining houses are opposed to this objective. The objective of offtakers is to secure access to the mineral in the ground for end use or trading. Since most trade buyers of mining assets pursue M&A to secure the mineral in the ground, having an offtaker with significant offtake rights on the shareholder register usually sterilizes an entrepreneur’s ability to sell his or her company in a competitive manner to the highest bidder.
Partnerships or earn-ins with large mining houses lead to a similar misalignment of objectives. A large mining house’s ability to earn into a control position or minority with veto rights, potentially combined with rights of first refusal or mandatory dilution provisions, means that an entrepreneur loses the freedom to sell the whole company to the highest bidder when the de-risking has been completed.
Despite its limited availability, for management teams with a successful entrepreneurial track record, private equity is financially the most aligned capital choice.