BMO cautions against excess gold sector royalty deals

A trend among gold developers to write royalties as a strategy to raise investor value amid a stifled financial market carries high risks, a new BMO Capital Markets report found this week.

Financial instability, market oversaturation, reduced asset value, complex tax implications, and operational challenges are just the tip of the iceberg, mining analyst and report author Rene Cartier said in a Jan. 2 note to clients.

“We broadly question whether the creation of additional royalties by project developers may be a prudent exercise and whether new royalties may become more of a mainstream occurrence,” Cartier said.

Driving the trend is the need for alternative financing given the industry’s deeply depressed equity valuations over the past decade compared with other near-record-setting valuations of companies in different sectors, such as technology.

Marked by multi-billion-dollar growth in the royalty sector in recent years, the trend offers a lifeline for junior miners struggling to bridge the gap between commodity values and company valuations, especially in a high-interest rate environment.

While industry leaders like Randy Smallwood of Wheaton Precious Metals (TSX: WPM; NYSE: WPM) champion the model for its risk mitigation and funding benefits, concerns centre on potential downsides, including reduced equity appeal and asset encumbrance. Key figures like Rob McEwen of McEwen Mining (TSX: MUX; NYSE: MUX) have strongly criticized the role of streaming and royalty firms, calling them “Faustian bargains.”

McEwen perceives these alternative finance firms as having taken advantage of mining companies, eroding their profit margins and stunting growth opportunities.

During the Precious Metals Summit in Beaver Creek, Colo. last September, he likened their influence to sirens drawing sailors to their doom on the rocks, insinuating a cautionary tale for those in the mining industry.

“There are a lot of mining companies that have made Faustian bargains, and the devils have been that smiling royalty or streaming company with the dollars in hand, and you can see the damage they’ve done to our market,” McEwen said at the time.

Cartier also calls for a cautious approach, stressing the critical balance between strategic company growth goals and risk management. From his perspective, several companies under BMO coverage have floated the idea of writing new royalties on their assets to shore up their coffers, with mixed results.

“While simple on the surface, in our review, we find the transaction structuring to be more complicated and time-consuming, compared to our initial expectations, and further amplified by tax considerations,” Cartier said.

Royalty transactions involve receiving a percentage of revenue from a mining project without contributing to operational costs. In contrast, metal streaming agreements require an upfront payment for the right to purchase a portion of the output at a predetermined price, often below market value. While royalties are typically revenue-based and passive, streaming agreements involve more active financial participation and a focus on acquiring physical metal at reduced prices.

Pros and cons

While the analyst advises caution, he also notes several positives to the increasingly popular royalty finance model.

As an example of how a company can effectively create a royalty on an asset and spin it out to a subsidiary, Cartier notes how former Great Bear Resources (now owned by Kinross Gold (TSX: K; NYSE: KGC) in early 2020 spun out a royalty subsidiary called Great Bear Royalties to manage royalty interests. That move was intended to address risks and reward shareholders without involving them in operating risks or financing exploration and construction activities.

The company spun off a 2% net smelter return royalty, along with $1 million in marketable securities and $500,000 in cash, into Great Bear Royalties, giving shareholders another avenue to gain exposure to the Dixie project in Ontario, while alleviating concerns about operational and financial risks.

That strategy has several positives, according to Cartier. Spinouts can potentially align with the fair market values of peer royalty companies, offering better multiples than standalone developers. Additionally, they provide a focused business strategy and could appeal to a broader range of investors, possibly setting the stage for future sales.

However, Cartier highlights several critical drawbacks. The process can be lengthy and requires many approvals. There’s a perceived reduction in asset appeal due to the encumbrance.

The necessary tax evaluations add another layer of complexity. With the influx of royalty companies and subsequent market consolidation, there’s a risk of oversaturation, Cartier warns, leading to competitive challenges and potentially still weaker equity valuations.

Cartier suggests that establishing these royalties early in a project’s lifecycle and separating them into subsidiaries could be a better strategic move, allowing for better management of tax implications and maintaining future operational flexibility, including potential public listings.

The broader economic implications of this trend cannot be overlooked. Cartier expects creating new royalties through spinouts might become a more mainstream approach in a market where equity valuations remain challenged, especially for project developers.