Risk Capital Scarcity in Mining: Sowing the Seeds for the Next Super Cycle

Q&A with Bert Koth, Managing Director and Partner, Denham Capital Mining Fund

Risk Capital Scarcity in Mining: Sowing the Seeds for the Next Super Cycle

Share prices have been rising as part of the overall equity market recovery. What are you seeing now in terms of capital scarcity?

Outside the gold sector, the share prices of junior mining companies, in line with the equity capital markets recovery since COVID-19, have seen about a 33% rise. That is quite significant. General sentiment would say that if the share price is up, then it’s going to become easier to finance projects.

However, outside of the gold space right now, we don’t think that’s the case. The current rises in share prices are due to trading, and a lot of companies still have limited trading liquidity. In many cases, we’re seeing that companies do not require a lot of capital to materially move their share prices and increase market caps.

The relatively limited pool of trading liquidity means that the development capital for these metals and mining projects is not actually available. While it’s helpful that share prices have increased for capital raising purposes, this does not mean that the capital for development is available. And many people don’t distinguish between those two factors.

How much capital is then available right now?

Over the last 12 months, approximately US$6.8 billion of equity has been raised by the mining industry. That is not a lot of money if you consider that the metals and mining industry has approximately a US$1.7 trillion market cap in total.

We can take a closer look at that US$6.8 billion. Only about 25% of the US$6.8 billion has been raised for developing mines, which is a surprisingly small percentage. One would think that when mining companies raise capital, they would spend the majority of that capital on developing mines. This means that, only about US$1.7 or $1.8 billion of development equity has been raised for metals and mining.

We can unpack this $1.8 billion further, where 60% of that capital has been raised by the gold industry and only 40% by mining companies outside the gold space. This means that only US$680 or $690 million of equity raised from mining projects has been from outside the gold sector, which is a really small amount of money given that the mining industry is approximately a US$1.7 trillion market cap industry. Over the last 12 months, hardly any development equity has been raised for mine development outside the precious metals space.

Another great metric to look at is the figure of required development capital over the market cap of the companies that own the development projects. That multiple is quite surprising. If you look at the multiple for mining majors, it’s a very low multiple.

In the junior gold space, that multiple is approximately two times, which means gold miners need about twice as much capital on the books to develop the projects than the underlying companies. This is a manageable hurdle because they can go off and do streaming, and there is a lot of cheap public market money available for gold right now.

But if you move away from the gold space and you look at mining juniors for other metals and minerals, that multiple, according to our calculation, is around 6.8x on average. This means junior companies that have projects outside gold need approximately 6.8 times as much capital to develop the projects than the underlying companies, which is a very high hurdle.

A year ago, or one and a half years ago, that multiple would have been 15x, so that number is coming lower. This is because of the sheer price increases that this multiple has come down. But it’s still a very high hurdle. And this is also true for all the green/technology metals companies.

Juniors in the green and batteries space still face this, very high financing hurdle. This means that the majority of these projects are going to end up financially stranded because the companies cannot raise the equity. If they can, it’s difficult to see how the boards of directors would endorse the capital-raising because it would result in massive dilution for the shareholders in the existing companies. Outside the gold space, there is clearly a significant scarcity of capital that is willing to assume the development risk in mining.

With the ongoing energy transition and the focus on decarbonization one would have thought that financing for tech metals and mining wouldn’t be a problem right now.

From a purely thematic point of view, one would believe that there is a lot of money being mobilized. But the numbers are telling a different story. And it does not help that, for example, in Western Australia, a lot of lithium projects have gone bankrupt, essentially wiping out all the equity that’s been invested historically.

It also does not help that there have been projects with significant problems in the past. That it very detrimental to investor returns. It does not help that, for example, in nickel, which is also regarded as a key battery metal, a lot of projects have elevated execution risk. So it’s complicated.

Let’s look at how ESG factors into this financing environment.

Having the right and positive environmental, community and stakeholder engagement and policies is the social operating license for any successful metals and mining project. And the media usually focus understandably on negative events like accidents, tailings dam failures, or when historically sensitive heritage sites get blown up – these are terrible things that should never happen.

But what is probably not understood by mainstream media and the broader public is the fact that in the vast majority of cases, mining companies really do the right thing for the environment and for the communities. What is equally not understood is the fact that a lot of these metals and minerals are necessary to deliver the energy transition. We will need much more metals and minerals for electric vehicles and for new energy. So there is a direct link between achievability of a zero carbon future and the need to actually significantly increase primary mining. And that link is not understood at all by the broader public, and also by the proponents of energy transition in most cases.

In some cases, ESG might be misunderstood by investors as a reason for not investing into metals and mining, leaving us with a long-term negative consequence where even less capital can be mobilized for metals and mining. This will then have a knock-on effect of a significant supply shortage further down the track for metals and minerals. And that supply shortage might put the achievability of a zero carbon future and energy transition itself at risk.

What do we do if this capital scarcity persists over the next few years?

It’s a really difficult question because those companies that are in production and those projects that will have succeeded in bringing themselves into production will likely be great beneficiaries of rising prices. And shareholders are going to do very well.

But then, for the broader society and for the desire to achieve energy transition and a zero carbon future, this is not good news. When you have much higher prices, it will ultimately push the prices of renewable energy and electric vehicles up as well. That then stands in the way of achieving these very important objectives. So I do think public education is necessary in showing how the mining industry is actually really important for achieving these objectives.

What do you see as the role of private equity in this space in helping to fund these types of projects?

As a private equity firm, most of what we do is actually assume the execution risk to develop projects into production. In our firm, we certainly have a strong focus on those metals and minerals that are necessary for energy transition and for general electrification.

So that is certainly our mandate. But overall, the pool of private equity that is out there is insufficient to solve all these funding needs. And that pool might shrink further since not all private equity firms that exist today will probably raise full on firms. So we as private equity investors can certainly step in and provide the development funding to some of these projects. But the holistic funding solution would require additional capital beyond private equity.

Where do you think that capital is going to come from beyond private equity? What is the right funding mix for these projects?

Streaming and royalties are typically all part of the funding mix for particular projects, so they’re not funding alternatives. They’re quite complimentary because even if a project is financed with a royalty financing, or a stream, it still requires equity as well.

All these different funding mechanisms are not substitutes or alternatives for each other, but actually quite complimentary – they’re usually part of the funding package, but none of them are usually a substitute for the equity.

The real shortage in the marketplace is the equity. It actually looks like it’s easier these days to get the debt than it is to get the equity. I’ve been in the industry for a long period of time, and I certainly can’t remember another period in my career where you quite regularly see projects that have raised the debt but are struggling to find the equity. And then the question is where is the equity going to come from if the public market doesn’t underline the equity in sufficient quantities, if the pool of private equity is not big enough?

We have certainly seen a lot of sovereign wealth funds having become very gun shy to assume development risk. Large mining strategics would certainly be part of the answer, but sometimes the combination of entrepreneurial risk capital with large mining companies is not so easy because entrepreneurial mining companies need to be very capital efficient to achieve as much, as fast as possible for very limited dollars.

In some cases, I think you’ll see governments coming in to support certain entrepreneurial project initiatives. But again, that’s not going to be the answer for everyone. It might be the case in a few situations, but it’s not a large-scale solution. Despite the fact that all the rationale argues that the risk equity gap in mining needs to be filled, I’m not sure where all the required equity is going to come from.

What do companies do in the meantime, especially those companies looking to develop clean energy metals?

Try to be as creative as possible about how to raise finance. It’s likely that the best of those companies will probably stand a chance to raise the equity, but not all of them. We have certainly seen a number of companies that you’d normally think are in great shape that have failed to attract the funding.

Some of them will succeed in raising the equity but many will not. And I think the only word of advice I have is that they should make sure that their investment case is robust and bulletproof. In some cases, it’s important to look at what is going to happen further downstream, because a lot of these technology and electrification metals and minerals actually also require a significant downstream component – it’s not just about the mining.

Companies also need to be as creative about financing as one can. There’s no universally applicable answer to all of these challenges – every situation is different.

So it’s more about being creative and having the right investment selling point for your company?

Yes, and only hit the market if you have a project that’s really good. In the junior mining markets most companies typically only have one, maybe two, projects. So the people who invested into the single asset companies and the people who run the single asset companies, they have already made their bet that it’s going to work.

Therefore, they committed the time they have already, in some cases, committed the seed risk capital dollars. Then, even if the project does not make a lot of sense, many of them will still soldier on and try to raise the capital for the project, because that’s what they have bet on – that particular project in the particular junior mining company. So, they will do whatever they can to basically attract the third party capital that’s necessary to advance that company.

Now, while that is understandable from an individual point of view and from a company point of view, it creates this very large universe of junior mining companies, all of who try to raise capital to advance themselves with a very high percentage of those companies in reality, not having a worthwhile project.

And we have investors looking at these thousands of junior mining companies and questioning which one is a good bet. For a mining-savy investor, that’s not a problem. But the larger capital markets are often populated with more generalist investors who might be confused about the projects.

It also doesn’t help that a lot of junior mining companies are misallocating capital. Coming back to that US$6.8/6.9 billion equity raise over the last 12 months, according to public information, about 22% of that amount of money is actually for channel corporate purposes. Look at that figure and 25% of equity raised in mining over the last 12 months has been used for project development, and 22% has been used for channel corporate purposes. So almost as much money has been spent on channel corporate purposes as on developing projects. That ratio does not make a lot of sense – it’s not capital efficient. A significant portion of these corporate overheads where listing fees, office rents, and board members, etc, means not putting capital in the ground.

It’s tough and it takes a lot of time and energy to filter through the opportunity set and to try to figure out who is for real and who actually has a genuinely attractive project. If that is a major effort for us, with the resources that we have as an investment firm, I must assume for a general retail or institutional investor, it’s much more complicated.

I assume that one of your investment criteria looks at how a company allocates their capital.

First, we look to see if the project makes any sense from an asset point of view. Is it really low cost? Looking beyond the spreadsheets and the feasibility studies. We try to focus on projects that have a lower execution risk and a lower implementation risk. Because within metals and mining, there’s actually quite a broad bandwidth of technical risk profiles.

We focus on those projects, that action at the low end of the technical risk curve. We look at the reality of implementation risk. We look at the economics. We look at the quality of management. And very often, we start business planning with management teams before they have the assets.

And then we agree with the new management team on a ‘hunting license’, which means we go with the management team after projects and mines that actually fit to what the management team has successfully executed in the past.

So the people are really important for us, the asset is important, and the execution risk is important. And now, because we probably still have another 12 months of COVID-19 travel restrictions in front of us, one of the things that we’ll look at is if we can carry out due diligence. Because we don’t believe in due diligence where people send their own drones flying and have GoPro livestreams and things like that.

We need to be able to send trusted people to site where they themselves can kick the rocks. Because if you rely on what people send you remotely, then you only see what the counterparty wants you to see. There is no substitute to having your own people with boots on the ground on the project to take a look at things.

At the moment, we only seek to transact where we can mobilize a critical mass of local engineering and metallurgical talent who can carry out due diligence on our behalf, but in close cooperation with all in-house technical capabilities.

That rules out a significant number of countries in the world. We have had to pass on a number of transactions in Africa not so long ago because it was literally impossible to get due diligence teams on site.

The ability to carry out due diligence is, at the moment one of our key filtering criteria in our deal pipeline. We hope that as a vaccine gets rolled out over the next 12 months that travel restrictions will relax. But right now, we still look at the situation where we don’t want to waste our time and also don’t want to waste anybody else’s time. We only want to look at transactions where we see a realistic chance to be able to carry out due diligence.

Let’s hope that the vaccine roll-out happens a bit faster than expected and we can all get traveling again.

It’s a real obstacle because it’s not only the technical due diligence. While Zoom calls and WhatsApp calls are all helpful, you can only progress a transaction commercially up to a certain point via electronic media.

There just comes a point where you need to sit down with a potential counterparty and not just once, but three or four times. Have dinner with them, crank open a bottle of wine, look them in the eye and figure out, “Can your vehicle co-exist with these people in a business venture or not?” And vice versa. So the human component of deal-making in most cases, or in many cases at least, cannot be entirely replaced with electronic media.

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