Issue 12
Financing Mining Projects Alternative Methods
In the face of renewed pressure on commodity prices that continue to redefine the term 'low cost producer', the mining industry steadily moves forward with vigour and optimism. To compete in this new world of lower prices and negative sentiment, companies are closing high-cost mines and restructuring operations in order to streamline their corporate structures. Even as they struggle in the face of this 'new world order', companies continue to display a serious appetite for debt and equity financing in their quest to bring new projects into production.
According to a report published by the Mining Journal, metal mining companies plan to spend $34 billion on new mines and expansions over the next three years. In terms of size, in the past 30 months, the number of projects expected to cost more than $500 million has nearly doubled and accounts for $19.6 billion of the total or 57%. Presently, there are six projects that will cost more than $1 billion each.
In the hunt for new projects, according to a recently released industry report, spending on non-ferrous mineral exploration surged from $2.1 billion in 1992, to a record $5. 1 billion in 1997. Altogether, this brings the mining industries current annual expenditure on exploration, merger and acquisitions, and capital projects to approximately $60 billion.
Where Has the Financing Come From?
In the gold mining industry, about $3 billion per year is generated internally from profits on existing operations and income from gold hedging. About $600 million is raised in shares and another $400 million comes by way of convertibles.
In recent years, there has been an increase in the use of the public bond market to generate funds for mining finance. The mining industry last year collectively issued about $1 billion worth of new paper. Historically, this vehicle had been used primarily by the base metals industry, where projects tended to be of sufficient size (roughly $100 million as a base) to justify their use. However, there have been some notable exceptions in the precious metals mining sector, such as the bonds issued by Newmont and Placer Dome, and the gold-backed issue by Normandy Poseidon of Australia in 1994, which had a highly innovative structure. Judging by the number of issues that have come to market so far this year, and those being planned, the use of bonds as a means to raise mining finance will continue to increase.
The balance of the capital required comes by way of the debt market. The syndicated project loan market is vast and has been used successfully to finance large and risky mining projects in a wide range of countries. This market is accessible to both mining companies with projects located in developed countries, as well as companies in the LDCs when assisted by the role played by the IFC and, recently, the EBRD.
Sources of Mining Finance
Traditional sources include :
- Export credit financing
- Multilateral Institutions
- Commercial bank loans
- Supplier financing & captive finance companies
- Production payment loans and advances
- Debt and commodity-linked securities
- Equity and equity-linked securities
- Internal cash flows
- Joint venture industry partners
There are also some non-traditional sources, such as:
- Host governments
- Leasing companies
- LBO funds
- Individual investors
- Investment management companies
- Institutional investors
Methods of Financing
Mine financing methods fall within two categories; debt and equity.
Equity Markets
Simply put, equity financing means that investors receive a share in the company in exchange for a cash contribution. It can come from existing shareholders or new issues and is, for the most part, permanent.
Types of Equity Capital Ordinary shares usually form the core of a company's share capital. The holders carry most of the financial risk in exchange for substantial rewards if the company prospers.
Preferred shares, as the name implies, afford differential treatment to the holder, which might include priority on dividends, voting right and priority in the event the company is liquidated.
Convertibles give right to holders to receive interest and repayment of principal on some specified basis. The holder may exchange the debt into equity of the issuing company, or sometimes a parent company, either over a continuous a period or at intervals during the life of the instruments.
Warrants are usually associated with debt issues and are attached in a similar way to the conversion option found in convertibles. The warrant is effectively the right for the holder to purchase a specific number of shares at a predetermined price on a predetermined date, or between two specified dates in the future.
What is Debt?
Fundamentally, it involves lending a sum of money at market interest rates to be repaid at intervals over a certain period of time.
Types of Debt
Debt
- Subordinate debt (also known as mezzanine financing).
- Senior debt which is used in project financing and will usually be secured or asset-based.
Debt Securities and Commodity-Linked Debt
- Bonds (instruments issued in bearer and negotiable form, whereby the issuer agrees to pay a specified amount of money to the holder at a predetermined date. Interest is paid either on a fixed or floating rate basis as agreed at the outset).
- Gold Loans.
The Balance of Debt and Equity
The appropriate debt to equity ratio for a given project is a matter of negotiation between the sponsor and senior lenders. Many factors are taken into consideration, including customary debt to equity ratios for the particular industry involved, market expectations and risk. The destination of the commodity produced is examined: is it being provided to an assured market, evidenced by an unconditional long-term contract, or is it subject to the uncertainties of general future market conditions?
It is rare for lenders to mining projects to consider debt to equity ratio greater than 70:30, with lenders usually ignoring capital expended by the sponsor prior to the feasibility study in this calculation.
Corporate Versus Project Finance
A mining company looking to carry out an expansion, acquisition or new project development involving a significant capital investment usually seeks some level of debt financing. If recourse financing is used, the lender of the funds has recourse for repayment to the company's cash flow from all its operations and security over all its assets. The lender's main concern is then with the total economic health of the company, how the new debt will rank with the total debt, and what future ability the company has to service the total debt. A large mining company might finance a project on its own balance sheet, using corporate debt and equity, but this is not generally an attractive option, despite lower transaction costs.
The corporation is at risk for the total amount of capital it has committed to the development of the project throughout the life of the mine, and the resulting burden on the balance sheet restricts its ability to expand further.
Project Finance
As an alternative to taking projects on their own balance sheet, mining companies have increasingly looked to finance new expansions and acquisitions through project finance. Under these borrowings the capital investment invoked will be repaid only from the cash flows generated by the project. The lenders will not have recourse to the company as a whole. Interest rates are higher than for recourse corporate finance, but higher leverage helps reduce the overall cost of capital.
It is the lender, and not the company, which is exposed to the risk of the cash flows being insufficient to service debt. As a result, companies are anxious to proceed with projects that can be highly leveraged or financed either entirely or substantially on their own merits. In addition, unlike corporate finance, project finance can be considered off-balance sheet debt, thereby allowing a high capital cost project to be developed without having a substantial impact on the mining company's balance sheet, exceeding corporate debt limits or increasing gearing ratios.
Advantages of Project Finance
It allows a mining company to finance a project beyond (is means while preserving existing banking lines, and to explore competing for investment opportunities. It limits the risks of a project to the company. It also improves the return on capital invested in a project by leveraging the investment to a greater extent. In an extreme case, the sponsor 's credit may be so weak, or the project so large, that it is unable to obtain sufficient funds to finance a project at a reasonable east on its own. Project financing may then offer the only practical means available for financing the project.
Disadvantages of Project Financing
Project financing will not lead to lower after-tax cost of capital in all circumstances, as it is complex and costly to arrange. It is structured around a set of contracts that must be negotiated by all involved parties. The necessary legal expenses involved in setting up the project structure, researching and dealing with related tax and legal issues and preparing the necessary project ownership, loan documentation and other related contracts will result in higher transaction costs than conventional financing. Project financing typically also requires a greater investment of management's time.
Evaluating a Project
Providers of project finance will pay close attention to the discounted cash flow or net present value analysis in their review of the project's economics. This is the value of the future cash flows of a project in present terms. In the base case, cash flow and sensitivity runs the discounted value of the future cash flows and should always exceed the amount of the debt outstanding. This ratio is known either as a loan life cover ratio (LLCR), based on discounted cash flows to the end of the loan period, or project life cover ratio (PLCR) to the end of the economic life of the project. These calculations arc expressed as:
LLCR = NPV of future cash flow to the end of the loan / Debt outstanding Debt outstanding
PLCR = NPV of future cash flow to the end of the project / Debt outstanding
For projects most susceptible to market risks, minimum base case cover ratios might be in the region of 1.75. Th at is, there is forecast to be 75% more cash in the project than is required to repay the loan.
For less risky projects, minimum ratios could be 1.25- 1.5%. If the loan life cover ratio falls below one, then there is insufficient cash in the project to repay the loan.
In addition, lenders will also look at the debt service cover ratios (DSCR) to determine whether the available cash flow, in a particular period, is able to meet debt service. Typical minimum, values are in the range of 1.2-1.4:1. As lenders also wish to see that the project is economically viable after the scheduled majority of the loan, they will measure what percentage of economically recoverable reserves remain after the loan is repaid. Typically, there is a cushion of 1.5 to 2 times loan life.
Cost of Funds as a Determinant of Funding Source for Development
The cost of capital is the rate of return required by a group of investors to take on the risk of a project. It is usually expressed as the weighted cost of fund s and determines whether the return to investors is as great as the percentage return, they could earn in a comparable investment opportunity. lt can be described in terms of financing rates showing the weighted average cost of the components of any financing package. For example, a financing package could be 30% debt plus 70% equity; 60% debt plus 40% equity; and so forth.
Estimating the Cost of Capital
The weighted cost of capital can be expressed as the weighted average of the required rate of return of equity, and the required rate of return for debt.
Cost of Capital = ( 1 - x)rc + x( l -T)rd
Where:
x = Ratio of debt financing to total investment value
re = Rate of return for equity
rd = Rate of return for debt
T = Marginal income tax rate on the project's income.
Note: The Cost of Capital is expressed as an after-tax rate of return. Because the returns to equity investors are paid after corporate tax, re is also an after corporate tax rate of return to equity. The return to debt, rd, is a pre-tax rate of return; it must be multiplied- by( I - T) to convert ed to an after-tax basis.
Estimating the Cost of Debt
Briefly, the pre-tax cost of debt can be calculated by the following equation for the rate of
return on debt, or rd:
NP = C1 / (1 + rd )+ C2 / (1 + rd )2 + C3 / (1 + rd )3 + CT / (1 + rd )T
where NP represents the net proceeds from the debt issue and C represents the pre-tax cash debt service (interest plus principal) requirement payable in instalments.
Estimating the Cost of Equity
Debt financing involves repayment obligations; equity does not and, therefore, the procedures for estimating the cost of each vary. The capital asset pricing model is useful for estimating the cost of equity for a project. As with any investment, an investor will only purchase a risky asset if he expects to get a rate of return that meets his criteria for the risk he accepts. The greater the risk, the higher the required rate of return. The capital-asset-pricing model expresses the required rate of return as the risk-free rate plus a risk premium :
Where:
Required Rate of Return =
Risk Free + Beta X ( Expected Rate of Return - Risk Free Rate on market portfolio )
The risk premium is a function of two variables. Beta measures the asset's incremental contribution to the riskiness of a diversified portfolio. As a measure of the asset's riskiness, beta reflects the correlation between assets returns and those of the market portfolio. The difference (the expected return on market portfolio minus the risk -free rate) is the market risk premium.
If a security's beta is 1.0, its return tends to track the market portfolio. [f the market portfolio increases by 10%, the stock tends to increase by 10%. If the stock has a beta of less than 1.0%, it will rise or fall less than the market. Conversely, a stock with a beta of greater than 1.0% will rise or fall more than the market.
Derivative Instruments
While a lot has been said about the place of derivatives in mining finance, there are a number of these instruments available that can be used to reduce the risk exposure associated with a project. Generally, these are risks associated with funding-costs, currency Fluctuation and commodity price volatility. Recently, there has been much debate between mining company executives and fund managers as to the use of these instruments, particularly when used to hedge commodity price risk. Fund managers contend that hedging takes the ability to profit from advances in market prices away from shareholders. Mining company executives, on the other hand, contend that it is their fiduciary responsibility to protect the company - and its shareholders - from the adverse effects of low market prices. This debate will doubtless continue for some time. Generally speaking, however, lenders are very reluctant to provide debt financing to a project not having any form of hedging in place in order to guarantee under base-case assumptions, a certain minimum loan life cover ratio.
Without prolonging the debate, it should be noted that the use of derivative instruments has enabled a number of projects that were marginal or unprofitable to obtain financing. In some instances, projects have been able to achieve lower funding costs due to the strategic use of these instruments.
Conclusion
The intricacies of mine financing are formidable, and can easily be misunderstood. As a consequence, they are often misused. While all mining finance structures share common features, they require tailoring to the particular structure of not only the project, but also the individual sponsor. That is where the challenges are and the rewards lie.
Michael Simon is Senior Manager – Mining Finance for MeesPierson N.V Headquartered in London he is responsible for developing the Bank's activities in the mining industry. MeesPierson, established in 1720, is one of the Netherland's oldest and most influential financial institutions and is part of the international banking, insurance and investment group Fortis. With offices in all major financial centres in the world, MeesPierson is engaged in selective market segments, including corporate and investment banking, and are recognised specialists in international trade and commodity finance. It currently, employs more than 4,000 people in more than 25 countries. Before joining MeesPierson, Mr Simon was a Director of the CPM Group, where he specialised in advising mining companies on financing and trading issues. Prior to joining CPM Group, he was Vice president and General Manager of Mocatta, where he was group executive in charge of its client-based trading group in New York and Australia.