This was first published in Mining World.
‘Alternative finance’ has long been a buzz term for the mining industry. The scarcity of capital due to the absence of traditional sources of funding for mining companies (read, debt and equity) has meant that mining companies have had to look elsewhere for financing. Enter the royalty providers, streaming companies and a myriad of other players offering a variation on the typical funding model. While this is no longer a new phenomenon, interesting dynamics are emerging.
The ‘alternative finance’ market
Historically, mining companies used a mixture of equity and debt finance to raise capital for the construction, expansion and development of their assets. For single-asset junior mining companies that process followed a fairly well-trodden path while commodity prices were high; an IPO in London, Toronto or Australia, followed by a project financing by well-established mining banks. While these processes were complex and time-consuming, there was a great deal of liquidity in the market and there appeared to be little need to look elsewhere.
Since the global financial crisis in 2008 and the downturn in commodity prices, those funding sources have been significantly constrained and, in some cases, have dried up altogether. Sensing opportunity, a new breed of financier entered the market offering new forms of finance. The likes of Franco-Nevada, Silver Wheaton, Sandstorm and Royal Gold gained market-share by offering a mixture of streaming and royalty products. Specialist ventures also emerged, such as London-listed Anglo Pacific Group, which focusses exclusively on mining royalties. The trend has had an undisputed impact on the industry; the total value of royalty and streaming transactions topped $20bn in 2015. The companies accessing what were once new and innovative financing techniques now include many long-established players, such as Vale, BHP and Glencore.
What is mining royalty finance?
A royalty is a right to receive payment based on a percentage of the minerals or other products produced at a mine or of the revenues or profits generated from the sale of those minerals or other products at a mine. In the context of alternative finance, a royalty typically involves a one-off up-front payment from the royalty holder in return for which it receives a contractual undertaking from the mining company to pay a specified percentage of future revenue. Mining companies can use the up-front payment for a variety of purposes; funding capital expenditure, general working capital, making acquisitions and even (as is the case for the recent Anglo Pacific/Denison Mines transaction) funding exploration of other unconnected assets.
Royalties can be granted at various stages of a mining company’s lifecycle, and for a variety of purposes. For example, they have been used as a substitute for seed-equity in order to fund feasibility studies and have been provided as a substitute to debt in order to fund the development or construction of assets. That being said, the royalty companies appear to have had greatest appetite to invest in mining companies with operating assets and which can demonstrate a proven source of production and/or revenue in order to justify the investment.
While royalties have been used frequently in the mining industry, there isn’t generally a 'standard form' of royalty and all tend to be fairly bespoke depending on the nature of the underlying asset. However, royalties typically fall into four general headings: profit based royalties, net smelter return royalties, production royalties and royalties in kind.
Attractions of royalty finance for the mining company
- No fixed obligations; unlike a debt financing, the mining company will be under no obligation to make royalty payments unless it is producing and generating revenue. Equally, unlike a prepayment, the mining company will be under no obligation to make fixed deliveries of a specified volume of production. The result is a significant degree of flexibility for the mining company. This can be particularly useful if a royalty is provided as a substitution for construction-phase debt finance as it avoids difficult discussions with lenders if construction is delayed and fixed debt payments need to be re-profiled. The very nature of a royalty arrangement is, in some respects, more suitable to a mining company than debt, given the volatile swings in commodity prices.
- Limited covenant package; royalty agreements have traditionally been short-form. Covenants can, in some cases, be limited to obligations to; (i) operate the mine in accordance with good industry practice; (ii) make decisions as if the mining company had the full economic interest in the asset; and (iii) provide regular reporting to the royalty holder (to enable it to audit the royalty payments). For a mining company this is a welcome relief; offering significant operational flexibility as well as cost-benefits when documenting a transaction. This can be a stark contrast to the extensive scope of a debt finance covenant package and the time it takes to document a transaction, particularly that of a project financing. While this author would argue that some of the royalty agreements are too short-form (or lack the initial structuring of some debt arrangements) to offer wholesale protection in times of distress, there is real sense is streamlining these arrangements as the interests of the mining company and the royalty holder should be largely aligned.
- No dilution or pressure to ‘exit’; the provision of royalty finance provides the mining company with access to capital without having to dilute its existing shareholders or having the pressure to find an ‘exit’ which can come with certain forms of equity finance. The result is that the mining company’s management largely retain control over the operation, development, exploration and expansion of their asset.
Drawbacks of royalty finance for the mining company
- Quantum; royalty finance has typically been provided in the region of $10m to $50m. If a mining company needs a significant influx of capital, for example to fund construction of a new asset, the provision of a royalty alone may not be sufficient.
- Interface with other forms of finance; without access to advisors who are experienced in hybrid financings, royalty finance may not sit well with other forms of debt finance. For example, if a royalty is being paid out solely based on revenue, project finance lenders will struggle to accept that another commercial institution is effectively ‘senior ranking’ in terms of cash-flow to any debt they provide. There are of course a number of ways to structure around this, but as a basic principle a vanilla royalty could have the effect of deterring other forms of investor.
Attractions of royalty finance for the royalty holder
- ‘Equity-like’ upside; because the royalty holder will typically be entitled to a percentage of revenue, it is able to benefit from upturns in commodity prices and from the growth of the mining company without having to provide any additional capital outlay other than the initial up-front payment. Equally, the royalty holder shares many of the benefits of equity without having to take a hands-on role in the management of the company.
- Insulation from production costs; depending on the type of royalty negotiated, a royalty holder can in theory insulate itself from spiralling production costs. Because its return is often based solely on revenue it is less concerned if the costs of extraction and refining increase over time. This can have the effect of simplifying investment decisions. That said, if production costs grow over the long-term and this has a material and detrimental impact on the underlying business of the mining company then it is difficult to envisage a scenario where the royalty holder remains truly insulated from all production issues (particularly if this were to lead to instances of real financial distress).
Drawbacks of royalty finance for the royalty holder
- Risk of transfer; in certain jurisdictions (principally in North America) a royalty holder can obtain an interest in the underlying asset. This means they are capable of binding a future purchaser of the asset, and are not limited to a contractual right to enforce payment against the mining operator who has sold the asset (and may have distributed the proceeds). In jurisdictions where that is not possible, certain royalty holders insist on securing the payment obligations against the assets of the mining company. That said, this practice is not consistently applied and, even where security is taken, it does not mean that the transfer/insolvency risk is always mitigated. For example, even where a company agrees to provide security to secure a royalty obligation, the value of that security may be diminished where the mining company has transferred its principal revenue generating assets. Equally, establishing the future value of a royalty when it comes to enforcement of security (and therefore how much the royalty holder is owed) can prove difficult unless the royalty is well structured.
- Limited recourse; often a royalty is granted with respect to a particular revenue-generating asset. This means that, unlike obtaining equity in a mining company with multiple assets, the investment will typically be tied to the success of a single asset and recourse can be limited to the revenues generated by that asset. If a particular asset experiences construction or operating cost issues then the royalty holder can find its investment exposed.
The royalty finance market is clearly no longer a new phenomenon. There are a growing number of companies willing to offer this form of finance and a proliferation of deals involving a royalty component. So what are the emerging issues?
Concerns around capital-adequacy and the growing cost of providing project finance debt means that banks have not returned to the mining sector in the same volume as was prevalent before the commodity crunch. In their place is a growing band of ‘non-bank lenders’, including specialist mining funds. Like all funds, they have an internal hurdle rate which needs to be achieved before they can make any investment. However, they are willing to be creative in order to achieve that hurdle rate and that often means offering a debt-piece alongside another form of alternative finance, such as a royalty. In some respects it allows them to fill the void left by debt and equity and become a one-stop-shop for finance.
For mining companies this continues to offer an important source of potential capital, but it is not without its drawbacks. Because of the internal hurdle rate, the cost of borrowing from these entities is invariably higher than traditional bank lending. In addition, mining companies need to carefully consider their long-term goals ahead of entering into a composite financing. Tying up future revenue for life of mine (in the form of a royalty) is often just a ‘bolt-on’ to the debt financing, but it can have significant implications if the mining company intends to refinance the debt further down the road with a more traditional form of finance. Voluntary prepayment rights under a loan agreement won’t count for much if the royalty remains and serves as a ‘poison pill’ for future lenders.
The mining funds are alive to these issues and, based on this author’s experience, are willing to look at creative solutions that cater for potential refinancing needs. One option is to agree detailed intercreditor arrangements with the royalty holder up-front which contemplate a lender coming into a transaction. This can prevent a mining company being held to ransom by an incumbent royalty holder, while offering the debt fund/royalty holder some protection against its internal hurdle rate being eroded.
The interface between a royalty holder and a traditional financier (whether providing debt or equity) presents an interesting dynamic, and one which is likely to become increasingly important if there is a resurgence in the rest of the mining sector. Indeed there have been recent signs of life; Mining Indaba had a more positive mood than in recent years; gold has consistently remained above $1200 per ounce; the world’s largest miner, BHP Billiton, recently returned to the black and paid a better-than-expected dividend; and new greenfield mining projects are attracting investment. If these signs do lead to a sustained recovery then traditional players are bound to return, as are more traditional forms of debt and equity finance.
It will be interesting to see whether increasing competition and liquidity in the market forces the royalty companies into new investment strategies. These could include, for example, a growing willingness to take construction risk or a move into emerging markets. Regardless of developments in the coming months and years, it is plain for all to see that royalty finance is here to stay. Indeed, in years to come it may no longer be seen as an ‘alternative’ source of finance, but rather as a customary part of a mining company’s financing toolkit. Dangerous words in the world of mining, but this could well be the new normal.