“Though one measurement shows the mining industry has seen its cost of capital grow by 5% over the past four months, 2018 could shape up to be a record year for fundraising in metals and mining.”
Metals and mining is one of Latin America’s oldest and most iconic industries in the Post-Colombian era. Despite its constant transformation over hundreds of years of boom-and-bust cycles, the storied industry is undergoing yet another transformation that could carry miners into another period of growth and prosperity.
In fact, multiple media reports are tracking ongoing fund-raising efforts by unlisted fund managers that could edge the industry past its blockbuster year in 2012, when institutional investors committed USD 4.6bn to sector-focused funds. This comes on the heels of struggle and declining fundamentals that metals and mining businesses have confronted the past several years when balance sheet leverage and pricing challenged even the largest miners.
The industry’s once steady dividends and cash flows had attracted all types of savvy investors ranging from the likes of Vanguard and Credit Suisse to retirees and day traders. But as soon as the commodity crash ensued in 2014 and prices plummeted, shareholders turned up the pressure to force miners to cut costs, pay down debt and adapt to 21st-century markets.
Just last summer, a group of activist investors, led by Paul Singer’s Elliott Management, called for corporate overhauls at the largest mining companies, accusing management teams of destroying value, reckless spending, excessive debt, and pointless M&A deals. Elliott even targeted BHP, the world’s top miner, lambasting management for destroying USD 40bn in shareholder value. Despite the acrimony, I believe management got the picture. According to the company’s annual report, management is preparing to divest its non-core upstream oil assets along with atoning for an environmental mishap at its Brazilian mining operation – BHP recently reached financial settlement with authorities and has been working with communities affected by a damn that burst in 2015 due to mining activities through its joint venture with Vale.
During the course of 2017, as the industry paid closer attention to shareholder disappointment from recent years, the top 50 miners reduced leverage by 32%, which was 200bps lower than when the year began. As prices rebound, the market expects miners to crank up dividends and cash flows, but most acknowledge lingering challenges remain.
Lessons in Leverage
“The return to growth is now driving the sector to determine optimal strategies for long-term value creation. Our view is that this can partly be achieved by reducing the cost of capital through maintaining an optimal capital structure. Indeed, the capital structure for mining companies continued to change,” note the authors of a recent EY report on the mining sector. “Mining companies’ weighted average cost of capital (WACC) is increasingly weighted toward the cost of equity as net debt falls. Reducing leverage has helped to restore balance sheet flexibility, but the bias toward equity funding, which is more expensive than debt, is increasing the overall cost of capital.”
Moreover, an obvious pressure point for miners is the US Federal Reserve’s “normalization” program of hiking interest rates, which will apply upward pressure on companies’ costs of capital.
A brief primer may be helpful to assess what institutional investors and CFOs are thinking and seeing. Central bank interest rate hikes will prompt investors to demand a greater rate of return on their global investments as the rates of “risk-free assets” in their portfolios, typically government bonds, increase. Utilizing the Capital Asset Pricing Model (CAPM) below – I could use the Dividend Discount or Sharpe Ratio methods, but most practitioners use CAPM to estimate the cost of capital – one can see how investors’ expected return on equity, which is used in WACC, will increase miners’ overall cost of capital.
So, what do the numbers tell us? According to the New York University Stern School of Business, the mining industry’s beta was 1.10 in 2017 while the school also found that the recently implied equity risk premium over risk-free assets is about 5%. The 10-year Treasury note – our risk-free asset – yielded an average of 2.44% throughout last year. Corporate finance chiefs can see using the example above that investors expected to be compensated with a 7.94% rate of return on equity last year. Presently, the 10-year T-note is yielding 2.82% – in March, the Federal Funds rate was increased by 25bps – which means investors will look for at least an 8.32% return, nearly a 5% increase in cost of equity over a few months’ time.
Looking ahead, investors can expect the investment banking and consultation industries to call on financially sound miners to use leverage to weigh down WACC.
Fundraising Gains Steam
While the reduction in leverage does reduce financial risk, investors will be swooned by the industry’s exploration of share buybacks, resumption of dividends, spending restraint, improvement in fundamentals, and a growing project pipeline, which bodes well for investment returns.
This has resonated with investors. According to an April 9th Mining.com article, fundraising among unlisted funds for investments in mining and metals is set to explode this year, potentially reversing last year’s trend. So far this year, Orion Mine Finance closed its Fund II after securing a USD 2.1bn co-investment vehicle – the USD 1.14bn Orion Mine Finance Fund I is the third largest metals and mining focused fund globally –; two small mining funds closed fundraising in Q1; while 13 additional funds are currently targeting the mining sector seeking a combined USD 4.9bn from sovereign wealth funds, public and private pension funds, foundations and family offices.
“If successful, it would make 2018 the best year ever for the sector. 2012 was the peak year for mining fundraising with USD 4.6bn of capital commitments from investors,” the article states, “… 43% of fund managers in the metal and mining space believe it has become easier to find attractive investment opportunities compared to a year ago. A majority of those surveyed say mining assets are priced about right, or consider them cheap. A third of the fund managers also say the competition for the best deals in the field has become more competitive.”
Essentially, the combination of attractive asset valuations and scarce competition for those assets makes the sector a compelling case for fund managers to pursue not only in Latin America, but throughout the world.
Expanding the LatAm Pipeline
Fund managers looking to deploy all that dry powder across various nations throughout Latin America will find plenty of projects. For example, the Ministry of Energy and Mines of Peru estimated the nation’s mining development pipeline in the first half of this year held a combined USD 49.9bn worth of projects.
Even Ecuador, better known for its oil resources, will attract investors to its burgeoning mining sector. According to BMI Research, the nation will increasingly emerge as a mining investment hotspot in Latin America thanks to a combination of revised regulatory framework, significant gold and copper reserves, and a policy of “inclusive agenda of development,” which is expected to be upheld by recently elected President Lenin Moreno
A topic I expect our panelists to discuss at Mergermarket’s Latin America Forum, which will be held in NYC on May 16, is the acceleration of M&A dealmaking across the mining sector. According to Mergermarket data, Latin American-based mining M&A transactions have grown from a low point of 17 deals in 2013 to 34 in 2017. Combine that momentum with international capital gravitating to the asset class once again and one can expect additional dealmaking over the near term.
Chile, a country home to major copper and lithium mining operations – 27% of world’s known reserves of the latter reside in Chile’s salt-encrusted, dried lake bed, Salar de Atacama – may play an outsized role in M&A dealmaking.
“… Our survey respondents ranked Chile the number one country they plan to target for acquisitions in the next year. This outlook is made even brighter by the fact that as of October 2017, copper prices had rebounded to a three-year high and many of the pro-union provisions in the new labor law have been struck down by the courts,” authors of a recent Mergermarket report found. “Political change is also on the horizon, as billionaire center-right former President Sebastian Pinera retook the country’s highest office in a December 2017 election.”
Memberships Play a Connected Role
Another critical factor contributing to mining and metals M&A growth in Chile is its associate membership in the Andean Community trade bloc, as well as its membership in the Pacific Alliance trade bloc. The latter, created in 2012, boasts Colombia, Mexico, and Peru as its members with Australia, Canada, New Zealand, and Singapore as associate members. Together, the member countries comprise the eighth-largest economy in the world and account for half of Latin America’s exports. Member countries have eliminated 92% of import tariffs among them and integrated their national stock markets into one trading platform called MILA, now the largest stock market in Latin America by capitalization.
If full membership is extended to commodity-hungry Asian nations such as China – presently an observer of the Pacific Alliance – logic would dictate that investors can expect an uptick in mining activity not only in Chile, but also Peru and Colombia.
(According to Mergermarket data)
“M&A data suggests the bloc has had an impact on inbound investment but has yet to fulfill its potential. Since 2012, inbound M&A in the four-member countries has fluctuated from a combined high of USD 48.5bn in 2014 to a low of USD 15.9bn in 2016,” the same Mergermarket report states. “Compared to Brazil, the region’s largest economy, foreign investment has been slightly higher in the member countries over the last six years, with a combined total deal value of USD 154bn versus USD 148.4bn in Brazil.”
Click here to join us the Latin America Forum, May 16th in New York, where dealmakers will not only discuss opportunities in metals and mining, but also other emerging sectors.