The speakers at a seminar hosted by Debevoise & Plimpton in New York this summer discussed both opportunities and challenges facing private equity firms considering investments in the mining sector. The seminar speakers included: Maurizio Levi-Minzi, a partner in Debevoise’s Mining Group; Hugo Dryland, Executive Vice Chairman and Global Sector Head of Metals and Mining at N M Rothschild & Sons; Erica Berthou, a partner in Debevoise’s Investment Management Group; and Stuart Hammer, a member of the firm’s Environmental Practice Group.
The speakers agreed that the mining industry as a whole has weakened considerably, as operating costs have risen substantially and commodity prices have declined and are either entering or recovering from a cyclical trough. Rather than deploying capital, many mining companies are facing pressure to return capital to their shareholders, and a number of mining companies have been disposing of non-core assets. This market environment provides potential opportunities and challenges for private equity firms considering investing in the mining sector. More details of Mr. Dryland’s presentation at the Debevoise seminar and the subsequent roundtable discussion are summarized below.
Opportunities in the Mining Sector
As a result of recent subpar investments by strategic investors and a corresponding reluctance among those investors to get involved in further M&A activity, private equity investors who can deal with the cyclical nature of these investments are presented with an opportunity to become engaged in the mining sector. Successful investments by private equity funds have generally fallen into one of three categories, representing options along the mining supply chain:
- Upstream investments in mining operations, which often focus on small and early stage ventures. These investments are subject to significant volatility in commodity prices.
- Downstream investments, such as smelters, refiners or specialty metals, which carry significantly less commodity price volatility than investments in mining operations.
- Structured investments, such as creative financing structures, often including royalties and streams as well as convertible debt and/or equity.
Mr. Dryland noted three key considerations for private equity investments in the mining sector: the commodity, the asset and the management team. With volatile and highly cyclical prices for commodities, timing of an investment is critical. In selecting an asset, it is essential for the investor to understand the risk (with substantially less risk in mines that are already in production as opposed to development projects), and to be conscious of social and political risks, which may be greater than in many other types of investments. Finally, a strong management team can extract value from a difficult mining operation.
Mr. Dryland also noted three models for future success by private equity firms seeking to invest in the mining sector:
- Providing capital for acquisitions (or development/expansion projects) for companies in need of financing. This requires clever structuring and possibly a willingness to stay invested for a longer time horizon than is customary for private equity investors.
- Supporting a management team to create a new mining company.
- Investing in special situations, such as loan to own, last money in, rescue financing and cost overrun funding, among others.
Ms. Berthou noted that the typical long-term investment horizon associated with mining could be particularly challenging for private equity investors, who look to operate a company’s assets and exit in accordance with a predetermined fund term. The panelists commented that so long as the investment is made during a favorable period in the cycle, for many mining transactions investment early in a standard fund’s ten year term leaves sufficient time to create value prior to exit.
Partnerships between private equity investors and strategic investors provide another opportunity for private equity involvement in the mining sector. A strategic investor will often combine financing from various sources, but will likely still face a gap in financing; a private equity investor can enter the transaction and structure an investment to fill that gap. These types of partnerships are not without issues, however. Strategic investors tend to be skeptical of private equity investors and may be unable to accommodate their higher return expectations or may prefer to incur a higher cost of capital rather than to share ownership of assets. For these partnerships to work, both sides will need to adjust their objectives and expectations.
Unique Challenges in the Mining Sector
The opportunities in the mining sector are not without challenges, and many are unique to the sector. There are two principal difficulties inherent in the mining sector that private equity investors must contend with: cost of capital and volatility, both of which may be better handled by strategic investors. Historically at least, strategic investors have tended to have a lower cost of capital than private equity firms, which has allowed them to pay a higher price for assets with financing. Additionally, volatility, which is a hallmark of the mining industry, makes it challenging for private equity investors to obtain leverage at the levels customary in other private equity investments. Strategic investors, on the other hand, may be better suited to secure leverage by pledging other assets as security.
Mr. Hammer pointed to the environmental concerns that certain private equity investors face in connection with many investments in the mining industry. Traditional risks and liabilities, such as issues related to the cleanup of contamination, exist in mining investments, but the related costs can be more significant than in other sectors. Additionally, investments in the mining sector present risks that private equity investors may not be accustomed to, such as those associated with the displacement of indigenous populations. Environmental issues associated with mining operations may also result in unwanted media attention.
The challenges and opportunities facing private equity firms seeking to invest in the mining sector are significant. Deep sector expertise, careful investment selection and timing, creative deal structuring and counsel experienced in mining transactions are necessary to overcome these challenges for firms interested in drilling for deals in the mining sector.