Mining’s private battle

The Private Equity and Mining Conference held in Perth last week highlighted the role of a new breed of mining investor but one that threatens more scrutiny than the industry has been used to receiving.

The resources sector has been losing traction across the key professional investing classes from whom capital could be sourced.

Specialist overseas institutions have been liquidating investments in response to redemptions from their funds.

Within Australia, the largest pools of money have never participated in the sector or have done so only reluctantly. Self-managed superannuation funds have retained historically high cash positions for the past five years and, within their equities allocations, have typically held only the best known large cap stocks. Within this space, a holding in BHP Billiton is the most common involvement in the sector.

The superannuation funds which have been capturing a growing pool of savings as a result of Australia’s compulsory superannuation arrangements have continued to shun the sector. The most commonly given reason for their absence as buyers is poor corporate governance practices among potential target investments. The credibility gap over how companies are run has been a fatal flaw in getting traction with this group.

High net worth individuals are the most likely source of risk capital but they also present structural hurdles for companies searching for funds. An aging population is producing a less sector friendly risk profile.  Also, as family wealth is more professionally managed by single or multi-family offices, more traditional portfolio decision-making tools with an emphasis on wealth preservation are being used. Second and third generation members of families looking to source income dislike the capital risk.

Those investors advised by licensed financial planners are also ignoring the sector in part because returns from the non-mining parts of the market have been so much better. There is a 100 percentage point difference over the past year between the return from large-cap industrial stocks and the return from the mid-cap resources stocks with the strongest development profiles. The financial planners are also hamstrung because their research providers generally do not offer a sectoral recommendation in a model portfolio putting the sector offside with compliance managers.

One of the few new sources of non-corporate funds is from private equity investors who have been drawn to the market by plummeting sector prices and pushed by portfolio strategists running endowment funds wanting to use commodities as an inflation hedge.

Despite their prominence as investors in industrial companies, private equity has hitherto remained aloof from the mining space. A distinction needs to be drawn here between mining and energy. There has been a long history in the USA of private equity involvement in oil and gas. Outside this space, the presence of private equity funds has been negligible. One manager in Perth last week put the total pool among the mining specialist funds at $A10-12 billion globally; not a big number when spread across all the projects seeking funding.

The resources sector provides some cultural challenges for the private equity investor (and vice versa). One of the motivations for endowments and pension funds investing through a private equity fund is to avoid the day to day volatility that accompanies participation in public markets either directly or through daily priced managed investment schemes. Since the vast bulk of resources companies are tempted to list on stock exchanges on the scantiest evidence of an eventual project, true private equity opportunities are hard to find. Private equity funds have had to bend the model to participate in the sector.

Looking forward, one of the more intriguing aspects of private equity fund involvement in the sector will be whether it stalls moves by mine developers to list prematurely allowing a more traditional private equity model to flourish.

Alternatively, private equity involvement could lead to companies being delisted as they move through a privately funded development phase before being relisted when cyclical conditions are more propitious.

There is a third way. The private equity funds might simply decide to limit their participation because they cannot apply the model they want to use and because their investors are reluctant to take on the daily volatility.

Private equity funds invest relatively large amounts of capital in single investments. The $2-3 million which might be critical to the early stage explorer might be far too small for the private equity manager seeking to invest one or two billion dollars in six or eight investments. At the smallest end of the market, which is where the bulk of companies are located, the private equity fund model appears unlikely to take hold without a change in approach.

A large proportion of private equity money comes from investors taking a macro view of the world.  These investors want to maximise the commodity flavour of their portfolios as a hedge against inflation. The often binary ‘success or failure’ exposure from explorers runs contrary to their investment objectives. This is more the realm of venture capital.

Most private equity fund managers will have very little discretion to modify the mandates they receive from their investors with respect to size, development duration, commodity exposure and returns correlation with equity markets. This will see funds most typically gravitate toward advanced projects from which near term cash flows can be generated to maximise the chances of an exit within the normal private equity investment horizon.

The most striking impression of the sector from last week’s meeting in Perth came from one manager who recounted the level of scrutiny to which his investment targets are subjected. This particular manager referred to having met with 100 companies in the past year and having commenced due diligence, including site visits, on just 15.

Due diligence, being time consuming and costly, is not undertaken lightly. And yet, in this instance, of the 15 potential investments only one was consummated. The primary reason for the other 14 falling by the wayside during due diligence was that, one way or another, each failed to fulfil its original promise.

Dishonesty was not the reason for the high dropout rate. Perhaps more worryingly, the high attrition came from company executives not having the necessary skills to understand fully the assets for which they were seeking funds. They had misled themselves as much as anyone else.

Hopefully, the one-in-15 ratio does not come from a representative sample. Unfortunately, however, it does ring true since the near doubling in the number of Australian listed resources companies over the course of the most recent cycle has left most companies with a wafer thin skill base for the tasks they face.

So many skills are needed as companies make their way from mineral exploration through mine development and metal production, all in a publicly listed company, that the chance of finding the full range at any one corporate office is slim. There is a high probability of a company’s skill base not matching what it needs at any point in time.

Even more worryingly, the one-in-15 statistic raises alarms about the reliability of the information that is being handed out publicly every day to entice new investors into public markets. Much of what is erroneous, inaccurate or misleading will never be put to the sort of test a private equity investor will employ in a due diligence review.

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