Mining private equity is being fundamentally transformed
Michael Scherb founder and general partner of Appian Capital Advisory talks to MINING.com about the particular nature of private equity in mining, how the industry if bifurcating and becoming more sophisticated and why now is the ideal time to be active in the industry.
Scherb, an Austrian national, started his career structuring foreign investment into burgeoning China before joining the mining team at JP Morgan Cazenove in London. He worked on deals as diverse as Rio Tinto’s 2008 defence against a hostile BHP, a $1 billion Istanbul gold mining IPO, M&A for France’s Areva in Africa and a bond offering for Russian diamond giant Alrosa.
Scherb also built up a reputation as an adviser to small and medium sized mining companies which developed into some of the leading names in their fields. Appian was born out of the realization that capital was poorly allocated to this segment of the mining industry.
Appian set out to raise $100m but ended up with $375m in the heavily oversubscribed offering with significantly more in co-investment funds, which gives the firm the ability to take advantage of large-scale opportunities.
He also managed to bring on board heavyweight partners including Rio Tinto, Anglo American and De Beers alumni who between them have built more than 60 mines, and a deep financial team from JPMorgan, Bain Capital and Barclays. Today Appian has teams working in London, Johannesburg and Melbourne.
After four investments, roughly 30% of Appian’s $375m has been committed. The firm has built up a track record for its long term commitment to projects and ability to assist with both capital structuring and operations optimization. In fact, 3 out of 4 investments are in construction and will be cash flowing next year.
Scherb says the company is ready to pull the trigger on another few investments in the near future: “Private equity firms really need to be more active now – it is a fantastic time to go long.”
“That’s not just because valuations are realistic and high-quality assets are now coming up for sale. Part of the problem is also the lack of sophistication of private equity groups entering the sector which have set overly restrictive hurdles before making investments.
“Generalist investors and even some mining investors have thrown in the towel. It's really going to take a brave counter-cyclical long term investor to be going in now. And there aren't many.
Scherb believes the benchmarks for private equity in mining is “probably overly onerous and now is the time to take on more risk. You have to be brave and long term in your approach in these markets,” says Scherb, who takes a deep dive into mining private equity in the Q&A below.
There has been a lot of speculation surrounding private equity in the mining space. What are some of the common misperceptions out there?
A couple years ago there was a large media campaign anointing private equity as the saviour of the industry. This was pure hype in my view because mining is such a capital-intensive industry and the new capital inflows are significantly less than what is required.
Private equity in mining is a misnomer because traditional PE principles don’t apply to mining.
Whereas most of the returns in PE are generated from leveraging a producing project or financial engineering, in mining value is created by providing capital and de-risking a project through the value curve into production.
You will see a bifurcation of PE in the industry with the large PE funds, which are curious about the potential alpha to be generated sniffing around but not really deploying because they can’t get their heads around the unique box of risks that is mining.
At the same time the select small specialist investment houses who only invest into mining will be much more active.
What works in mining is strategic capital, not discretionary capital. PE in its purest form doesn’t transfer over into mining. That’s because it makes use of leverage and in mining it is easy to get caught in a price downturn.
Do you think PE in mining will be a growing phenomenon or is the current environment remarkable in some way?
PE in a mining context is here to stay, and there is a structural secular shift happening in the industry in the way that it is funded.
If you look at every other down cycle, PE didn’t really catch on. This time it’s different given the rise of new funds, some of which are very active.
What I find interesting and encouraging is that the industry – which includes management teams used to historically raising short term retail capital – is slowly adapting itself to accommodate PE capital.
You’re seeing the same changes in mining that you saw happen in the oil and gas industry which is now heavily supported by PE.
Mining projects will stay private for longer and you will see many new projects being backed with a large PE cornerstone investor, whether public or private.
Having said that, there are roughly 10-15 new mining funds raising capital from investors now, but what we’re hearing from institutional investors is that most of these will be unsuccessful in raising money.
What do you say to those who believe PE is not suitable for the mining sector because for example the time horizons are too long or it’s too risky?
PE is perfect for mining because the industry finally has long term capital matching up with a long term industry.
A lot of the problems inherent in mining are driven by pairing up short term capital with a long lead time industry. PE is structured as a 10 year closed end fund structure which allows a through the cycle approach relative to asset management or retail who want immediate results from management.
Why should a company need to raise exploration capital publicly which requires quarterly results and short term press releases for a project that will only produce in five years time?
PE capital provides management teams the long term financial support so that they can focus on what they do best which is to develop the project rather than spend their time cap in hand fundraising, putting out press releases or attending useless trade shows.
Just ask a public junior CEO if he would rather be a cashed up private company or a cash starved public company beholden of the whims of the market and short term investors. The industry is overly fixated on short term share price movements and press releases, but as we see, no one cares in this market environment. The value creation should be real, and we view that as de-risking a project up the value curve and bringing it into production.
How would you characterize your fund versus what is considered the norm in PE?
There are a few specialist firms globally who only do mining including Appian, who we respect and like to look at projects together.
I wouldn’t classify them as PE, rather mining specialist investment firms because the traditional PE principles of leverage and financial engineering don’t apply, rather long term partnerships.
What is the size of the funds you can deploy? And roughly how much do you estimate is the total pot of PE earmarked for mining?
We look to deploy between $30 – $150m in a few select projects and teams and if we find the right large project we will ask our investors to invest more alongside us, so that size range increases.
As for the total pot earmarked by PE for mining, the actual capital earmarked for deployment is far less than publicly announced as the majority of that capital isn’t solely earmarked for mining, but usually part of larger generalist pools.
In addition, most of it isn’t invested at the discretion of the mining fund managers, but the managers need to go back to investors to seek approval. Appian controls pure mining focused capital investable at our discretion.
Do you have a company size or percentage stake preference when you consider investing or does it depend on the particulars of the deal.
We are seeking preferably private, but also public, companies in the base metal, precious metal, fertilizer and select niche commodity sectors.
We want to invest into projects or teams which are at a maximum three to four years from production, producing now or brownfield in nature.
Given our technical focus and the current environment which is favourable to accelerating production, we can actually move a little bit earlier than in the past.
You can hit a project with more drill rigs because drilling costs have come down or optimize capex because you can now get equipment quicker and cheaper. At the same time with producing assets we can do production optimization.
What are some benefits management teams get for having PE as an investor?
There are many, but here’s a list off the top of my head:
• Allows management teams to focus on what they do best, which is build the project
• Removes the financial burden from management, as a long term funding solution, so they don’t have to waste time fundraising constantly
• Provides access to capital across cycles, not just when mining is fashionable
• Removes time consuming investor relations, public relations and conference requirements via the full funding solution
• We structure our deals to provide management teams a lot of upside, so a potentially more aligned and lucrative incentive structure
• Collaborative partnership with management – management teams benefit from our financial and operational skills and industry relationships which we fully open to our portfolio companies
• A lot of shareholder registers are overly diluted through multiple raisings and a long term value build cornerstone investor, for those that don’t have one, will also provide greater defence against a low ball, speculative takeover offer, many of which are occurring now.
If you’re asking why PE versus other forms of financing, we are just beginning to see some of the downside to management teams giving away the farms to the new style alternative investment structures.
What do you say to boards who don’t want to raise capital at what they see are depressed share prices?
It is an important issue and many factors go into this discussion, which is one we have often. Firstly, I have yet to meet a board who feels that they are overly valued, so it is good that they are doing their job!
The consideration though is, who knows what the market will be in six, 12 or even 24 months? There is a good chance it could be worse than it is now, and the boards will wish that they raised more now. For example, there are many who missed a window and wish they would have raised capital 6-12 months ago.
The benefit of having a supportive long term partner, is that we will be there to ride out the cycles.
It should also be noted that any delay or stall in the project’s development is also highly dilutive to the project NPV and ultimately returns to shareholders, and people don’t usually model the financial impact of this to the share price.
Now is actually the ideal time to build a mine and drilling costs have come down rapidly as have development costs, so there is also a fiduciary responsibility to shareholders to take advantage of this situation and waiting until drilling and development costs are back to their peaks is also highly dilutive to ultimate shareholder returns.
The ability to accelerate development now while most pull back, has the potential to create tremendous value, and the overall pie to be shared amongst everyone will ultimately be larger so an absolute focus on what the share price is, is not taking into account possible value creation over and above what could be created in a different market price environment.
What the industry needs is more visionary boards who break the norm and are able to think counter-cyclically and through the cycles.
A cornerstone investor, for those that don’t have one, will also prevent a low ball, speculative takeover offer, many of which are occurring now.
Do you believe the mining cycle has bottomed? Have valuations come down sufficiently to spark a pick up in acquisition activity (not just from PE)?
What I will say is that people are overly bearish in the downturn and bullish in the upturn and this feeds into the cyclicality of the industry.
For example, research analysts putting out bullish price forecasts which feeds into target prices or management teams making the wrong strategic moves at the wrong point in the cycle whether it be taking out debt or ill-timed M&A, because either their advisors or shareholders put pressure on them.
On some level, the fact that people keep making these mistakes, allows a long term through-the-cycle investor like Appian to take advantage of the inefficiencies created.
Having said this, I think we have a few more years to run actually, because I don’t yet see what will re-rate the sector in a positive way.
If you look at the large mining companies such as BHP or Rio Tinto as a proxy as I do, they seem bent on maintaining a 5% dividend yield when their historical average is 3%.
Why would they do this if their margins are being compressed? Well, because of pressures from their short term investors who need to show progress on a quarterly basis.
This is coming at the expense of capex expansions or exploration and in a sense the majors are sowing the seeds of the next cycle by not investing in exploration.
I think the sector could see some positive movement when these cutbacks feed their way into the system, so a few years.
Last year saw a huge pickup in interest in base metals. Which sectors do you favour? Are there any you would totally avoid?
We are after base metals primarily at this point in time, but will also look at precious metals, met coal, fertilizer linked commodities and some niche plays – the likes of niobium or rare earth – as well.
We take on more exploration risk than most PE players, but something still needs to be in production within 3-4 years, as determined by our internal team which may be able to accelerate things, or preferably closer to production or in production.
We are staying away from most bulks like iron ore but it is still possible to play Chinese growth if you concentrate on mid-cycle commodities like copper or late cycle sectors such as rare earth and other specialty metals.
Are there any jurisdictions you stay away from or favour above others?
At this point, we are looking very closely at projects in North America and South America, but Africa is an important jurisdiction as well if you can get appropriate risk adjusted returns.
In South America certain jurisdictions remain risky and there are probably only around eight or so African countries we would invest in. We stay away from the DRC for instance. We’re also looking at Australia.
If you had to choose one or two selection criteria that you consider most important what would it be?
First thing I look at, is this project defensive enough to get into production through the cycle? That involves an operational, financing and softer issue analysis.
Secondly, is this a management team I want to partner with for the next 3-7 years?
How many projects do you consider, advance to due diligence and what proportion do you ultimately approve?
The Appian due diligence process is quickly becoming known for its rigour.
We aim to make 3-5 core investments a year. We will probably have fewer positions but those positions we do have, we have long term conviction on. These are investments we will back all the way through to production and will support in good times or bad, so it was time well spent. While our due diligence is longer, we are supportive long term investors.
We’re making a 3-7 year investment not a 3-7 minute investment.
Do you have a preference for private versus public companies?
We can cornerstone some public investments, but without a doubt private, and it is a function of the industry that mining companies go public far too early in their life cycles, but most public market junior CEOs wish they were private in these markets.
Its odd that such a capital intensive industry was backed in a venture capital type approach. At these points in the cycle that speculative risk capital isn’t there, leaving management teams stranded.
In an ideal situation, a private company would get together funding for drilling to determine a resource, PE would then step in and back it into development or near development and raise capital in the public markets for the final completion capital or to sell down to institutional investors. This model worked really well in London and we managed to grow some of the leading companies in the industry in this manner.
Why public juniors want to continually pay listing fees, continually report to research analysts and conferences and report quarterly only to be overly punished by short term investors in the downturn is beyond me, and unfortunately a model which is all they have had exposure to.
The industry needs a complete re-think, and change is often driven by necessity.
This point in the cycle is a good time to alter everything from funding strategies to the way corporate governance is looked at by the industry.
What advice would you give a company before they come and bang on your door asking for money?
Come prepared. We looked at 300 projects last year and made 3 investments. Our due diligence is longer, but we are long term collaborative partners, and do all we can to back a project into production over the long term.
We have a 14-person team, so we don’t have the luxury of wasting too much time, so I would encourage all the companies to ensure that their documentation is ready for a thorough review and have a detailed presentation and technical documentation for the first step review before we dig into the resource model and mine plan.
What is one area which still needs to develop before PE becomes a primary feature of the sector?
Without a doubt corporate governance, to ensure that all investors, particularly retail investors, are protected.
Corporate governance in many companies we have looked needs work.
Quite simply, people don’t know what the term means, certainly not in the tone of a mature London listing. There seems to be a lack of understanding that good corporate governance is a great thing for a company and results in positive share price movement over time, however it is seen by some teams as giving away centralized power.
This has become a focus for our diligence, and I continue to be amazed that management teams would be in disagreement to having a solid, relatively independent view from a board of directors and it’s a red flag for us when management teams don’t agree with this approach.
The junior mining sector definitely needs a clean up and a shake up. I would also encourage all retail investors to look closely at how companies are run before buying shares. For example, if you notice board members sitting on each other’s boards, there is no way that they will ask each other the right questions.
If management and the board have a history of granting themselves options without accomplishing much or relative to share price decline, stay away. I think the Toronto Stock Exchange can do more to protect retail investors in this regard.
The ideal situation is to have a well incentivized management team on the upside of a project surrounded by a relatively independent and highly experienced board with diverse skill sets which leads to collaborative and thoughtful discourse. We want our management teams to do really well and never have to work again, and the project needs to be a success.
I’m not talking about putting pressure on management which is usually not constructive, but not asking a management team if they have actually modelled the potential share price impact of a decision is not conducive to positive share price movement or good corporate governance.