ALL the fund managers speaking at a mining industry gathering in Dubai last week said they would be less likely to invest in companies that had ceded control of their output to attract early stage funding. This poses a dilemma for many early stage miners running out of funding options in the currently tough financial environment.
Four fund managers from North America, Europe and Australia spoke at the MENA Mining Show in Dubai last week about the outlook for funding resource projects in the region and, more broadly, what investors were looking for when they assessed the attractiveness of a sector investment.
The single point on which they all agreed strongly was that companies were inclined to give away offtake rights too cheaply. All the managers said they were less likely to invest in a company that had given up control of its output. "The anxiety being expressed by the fund managers in Dubai reflected their combined experiences of companies more often than not appearing oblivious to the value erosion they have caused." They said a company could be taken off the investment radar entirely due to the nature of the offtake agreement it had struck.
George Ireland, head of the billion-dollar Boston-based Geologic Resource Partners fund, said that directors often failed to understand the value contained in offtake. Consequently, they also failed to understand the impact of their decisions on the underlying investment attractiveness of their companies.
Ireland’s comments were echoed by managers from TD Asset Management and Barclays Capital as well as your correspondent speaking on behalf of E.I.M. Capital Managers.
Ultimately, a mining company has to sell what it digs out of the ground. In one sense, investors should not care to whom the product is sold as long as transactions occur at an arm’s length price.
There are two qualifications to this argument. Investors are always going to seek some assurances about the bona fides of a potential buyer. They would want to know the likelihood of the buyer walking away when faced with a change in market conditions, for example. Also relevant would be the extent to which a buyer is only a middleman relying on other parties to ultimately take and pay for the prospective mine output.
These questions could arise in any event and can never be dealt with completely. Having a suitably diversified customer base might be the only possible protection.
For some materials, even these questions may not matter greatly. Copper, for example, can be readily sold on terminal markets making contractual relationships less important. Gold is even more easily sold. However, in the case of copper contained in concentrates, contractual arrangements with smelters might be vital to successfully generating revenues depending on the metallurgical properties of the product being offered. So too for mineral sands and rare earth elements.
From a company perspective, having another party agree to take all or a large proportion of the output of a new mine is generally reckoned to reduce project risk. It should bolster the confidence of bankers making them more likely to support development funding. Consequently, it might appear strange that potential investors are objecting.
One reason for the criticism is that negotiations are not always about offtake alone. When companies flag their willingness to swap offtake for equity funding, they are acknowledging implicitly that the offtake has value but leave themselves vulnerable to economically stronger negotiating partners in pricing the value of the offtake asset.
A history of indifference among companies to the idea that capital comes at a cost also makes fund managers sceptical that directors will get the better of the subsequent deal making.
Offtake agreements in which companies cede a large equity stake, perhaps with attaching options and commitments to incoming investors, who might be granted security over some or all of the assets, that they will not suffer any subsequent dilution to their equity stakes are becoming more commonplace. These arrangements come at a cost to existing investors.
The anxiety being expressed by the fund managers in Dubai reflected their combined experiences of companies more often than not appearing oblivious to the value erosion they have caused.
A trading house that agrees to take all the output of a new mine, contributes capital that might be equivalent to 15-20% of the equity and extracts an agreement that their position will not be diluted puts itself in the investment box seat well ahead of other investors.
Further down the track, as a project is de-risked and potentially becomes more attractive to a widening range of industry buyers, the presence of the trading house can effectively deter any interest. The trading house has effectively obtained an option to buy without the value of the option being priced into the deal. Any takeover premium investors might have otherwise anticipated will have been lost.
Board positions are also coming with these arrangements. While directors are supposed to take account of the broader interests of all shareholders, reality dictates something different especially where Chinese parties have invested in support of a well-defined national strategy. Only the most naïve of portfolio managers will believe that directors installed by Chinese interests will place a priority on the financial wellbeing of portfolio investors.
Portfolio investors are at risk on numerous fronts as a result of the initial contemplation of an offtake arrangement.
Macphersons Resources offered a recent example of how the savvy financier will seek to package a deal with a larger array of variables that the typical portfolio equity investor has at his disposal. Macphersons entered into an agreement with financier Red Kite in which, among other things, Red Kite is going to be paid a silver marketing fee of 15 cents per oz. On its own, that is a tiny proportion of the silver price and, as the company argued, a small price to pay to have a group like Red Kite along for the ride.
But silver requires no marketing especially in Australia where the Perth Mint acts as the de facto single desk for the gold and silver mining industry. The so-called silver marketing fee was little more than a way for the financier to defray its cost of capital.
There is nothing ethically dubious about this sort of deal. The key point here is that the value of the company was not enhanced by having this arrangement.
At the conclusion of
the Dubai discussion, many of the companies present expressed some concern, even dismay, that their attempts to attract offtake partners were not as welcome as they had anticipated. And, at one level, perhaps the fund managers were being a tad unreasonable. Pulling together an offtake agreement might be the only way a company can get a mine development underway. But there are two questions here that need to be clearly differentiated.
The fund managers – all of whom had a strong value orientation – were asked what affected their decisions about whether to hold a stock in their portfolios. That is most likely a different question to the one being asked around the board table, namely, how to facilitate mine development as quickly as possible.
A technically successful mining operation could still be a poor investment. Companies need to be clear on this distinction. They are free to choose either course but the Dubai fund managers were saying that the two will not always coincide.
