Will private equity save the mining sector?

With the mining sector in its third year of a painful downturn, a collective realization is setting in that business as usual isn’t going to cut it anymore.

The public markets remain extremely difficult for miners, metals prices are languishing and investors have long since fled to greener pastures.

“I think what’s happening here in the last twelve or eighteen months, it’s taken people from la-la land down to reality, and they’ve been able to hang on in the reality,” says Isser Elishis, managing partner and chief investment officer of gold-focused private equity firm Waterton Global Resource Management.

“What’s going to happen in the next few years is people are going to get swallowed up by the earth.”

Elishis believes commodity prices, which have already been hit by slowing growth in China, are headed lower in the short-term and that the mining downturn has several years left to run before the positive long-term fundamentals reassert themselves.

Not everyone shares Elishis’ downbeat view, but few believe 2014 will be easier for miners than 2013 has been.

There is some hope, however, that private equity (PE) will help fill the vacuum left by the public markets.

According to Howard Burshtein, a partner at law firm Baker & McKenzie, private equity firms are expected to raise $10–15 billion in 2013 to invest in the mining sector.

“We’re at a point in the downturn now where it’s starting to make economic sense for different players to come into the space,” said Burshtein at a presentation sponsored by Baker & McKenzie, accounting firm and consultancy BDO and alternative investment firm Brookfield Asset Management (TSX: BAM.A; NYSE: BAM) in October.

Burshtein, who has been advising companies with regard to private-equity investment, noted that mining deals represented 6% of PE activity in 2012. That number is expected to grow this year.

Some of the big private equity players that have raised money to invest in mining include companies with many years of experience investing in mining, like Resource Capital Funds ($2 billion), and Brookfield’s BCP III ($1 billion). Newer players include ex-Xstrata boss Mick Davis’ X2 Resources ($1 billion), and generalist firm Apollo Global Management ($1.3 billion), which are also looking for acquisitions.

Despite the buzz around private equity in mining, few deals have actually been announced — at least in relation to the amount of money that’s been raised.

Ross Bhappu, a partner at Resource Capital Funds (RCF), a mining-focused private equity firm that raised its first fund in 1998, believes that will soon change.

“Private equity funds are being patient and cautious about how they go about investing,” said Bhappu in an interview in November. “I think you will see more and more private equity funds deploying capital at this depressed period of time in the equity markets.”

What are PE firms looking for?

Outside of a few resource specialist firms such as Resource Capital Funds, private equity is a relatively new player in the mining industry.

Private equity has shied away from the sector in the past for many reasons: lofty valuations for companies, volatile commodity prices, a lack of technical understanding of mining and the fact that the public equity markets have been a more than sufficient source of capital.

Now that many of those concerns have abated, at least temporarily, private equity is looking for deals.

Unlike the leveraged-buyout model (think Bain Capital) that is often associated with private equity, PE firms investing in mining have a flexible investment model with a full range of debt and equity options at their disposal. They are all over the map when it comes to commodity focus, and while producing, cash-flowing properties are generally preferred, niche players exist that focus on earlier-stage projects or distressed assets.

It all depends on the fund manager, who comes up with the investment strategy or thesis for a particular fund.

In general, private equity firms look for assets in mining-friendly jurisdictions, and to invest in companies with high-calibre management teams.

Some firms will focus on assets rather than investing in companies.

Waterton, for instance, has bought two gold mines in Nevada this year — Hollister out of Great Basin Gold’s insolvency proceedings, and Newmont Mining’s (TSX: NMC; NYSE: NEM) Midas. Minvest Partners, a spinout of Minerx Capital, is looking to buy earlier-stage gold assets, and advance them through the prefeasibility and feasibility stages for later sale.

Hands-on approach

Regardless of the focus or investment structure of a fund, what all private equity firms have in common is a focus on the bottom line and a hands-on approach that’s meant to maximize their returns.

“Private equity funds typically have a specific, minimum return threshold for both the fund and for each investment,” said Peter Gordon, a managing partner at Brookfield Asset Management in an email exchange in November. “Once an investment is made, the private equity fund manager will look to the portfolio company CEO to deliver results that meet or exceed that return.”

The stakes are high for private equity firms, as the performance of their funds will dictate both their returns, and how easy it will be to get investors to commit capital to their next fund.

Under the private equity model, when the assets are liquidated from a fund and capital is returned to the investors (or limited partners), the fund (or general partner) generally gets a 2% fee and a slice of the fund profits — a carried interest of 20%.

In order to shepherd their investment, private equity firms will generally take a seat on the board of their portfolio companies.

At the presentation in October, Gordon warned mining executives in the audience that the direct relationship between a portfolio company and private equity can be intense.

“This is a returns-driven model,” Gordon said. “We deal with sophisticated investors, so if you think your shareholders are difficult and demanding, understand that the investors and partners within a private equity model that I report to are demanding.”

Some management teams might chafe at such a high level of involvement, which is likely to include a rigorous review of capital spending and improved governance practices. But Resource Capital Funds’ Bhappu says most portfolio companies welcome the guidance that private equity can bring, and that having a board seat gives RCF more insight into problems at the project or mine.

“The executives we’re dealing with really look to us as a partner, and I think they view us as offering much more than just a source of financing,” says Bhappu, who adds that Resource Capital Funds has invested in 117 companies since its inception.

“On occasion, there are times when we might take a different view from management on how best to take a project forward, but I would say that’s rare — way more the exception than the rule.”

A private equity investor can also mean greater access to resources for portfolio companies. Brookfield’s Gordon pointed to one portfolio company that was having trouble negotiating a new power purchase con
tract for an operation in Alberta. An expert within Brookfield’s large power group was able to help out.

“We are very much interested in supporting the further growth of portfolio companies,” Gordon said.

Long-term investor

Unlike capital market investors, who have long fled the mining space, private equity has the time to wait out the downturn.

A fund’s life can be as long as 12 years: a fund will have several years to invest capital committed by its investors, and several more years to see the portfolio value grow before the assets are liquidated and capital is returned to the investors.

That long-term focus makes private equity and mining a great match, Bhappu says.

“There was a period where hedge funds were active in mining and money was raised from various other sources, but I think the issue there is you get redemptions and you get groups that invest that are forced sellers,” Bhappu says. “That’s different from the private equity model where you can sit there — the share price goes up and goes down — private equity really is not looking at it that way: we’re looking at it as a long-term, patient investor.”

Bhappu’s comments are echoed by Waterton’s Elishis, who noted that investors who are focused on quarterly results may not be willing to give mining companies the chance to work through the longer-term problems that come with the territory.

“I think the issues you had over the last years, you had a lot of short-term, fast-money chasing opportunities, which, by definition are long-term — which is why the proper private equity application is relevant,” Elishis says.

“If you take the long view and the money is matched to the problem and you have the right people solving the problem, you’re going to get there. But if you have a problem that takes two years to solve and your money wants a report and results in a quarter, you won’t.”

While private equity senses value in the mining sector right now, the $10–15 billion that’s expected to be raised for mining investment is just a drop in the bucket for an industry that has been starved of capital for over two years.

“It’s such a big industry and the amount of money needed right now is much greater than the amount of money that private equity firms are able to fund,” Bhappu says.

Whatever the actual amount is, the capital that eventually flows from private equity will be significant for the mining sector, which will only raise an estimated $2 billion on the public markets in Canada this year.

Brookfield’s Gordon noted that this figure, which was compiled by CIBC and only takes into account financings of $10 million or more, is down nearly 80% from the five-year average.

Because there just isn’t enough private equity money to replace the missing capital from the public markets, the mining industry will have to temper its expectations of private equity.

Waterton’s Elishis notes that the asking price for assets is still far too high because juniors and many smaller mid-tiers don’t understand the differences between retail investors and private equity.

“Private equity is not just like a retail investor who wants to see the stock go up,” Elishis says.

“In order to justify the capital we put out and the risk we take, we need to make an extremely attractive return,” he adds. “People that have assets have to understand that groups like ours will understand what the value is, and will pay real value for it — but we’re not going to overpay for assets.”

Waterton is about to wrap up fundraising for its second fund, which will have $1 billion in capital to deploy starting in the new year.

If the industry is looking for a white knight, Stephen Stewart, a managing partner with gold-focused Minvest Partners, says it will have to look inward.

“I think the industry’s going to have to do a lot of self-healing,” says Stewart, who adds that miners need time to readjust to high costs and lower commodity prices.

“I don’t think private equity on its own is going to heal the industry, but it could very well be a catalyst to allowing the traditional investors — i.e., institutions and retail — to forget their losses and be able to jump on the bandwagon, because there’s good news again.”

— This article originally appeared on The Northern Miner’s sister website www.miningmarkets.ca.