Funding Methods Part 2: Debt
The most recognizable form of financing is easily debt. From mortgages, to auto loans, we are familiar with the basic concept of debt lending. The same concepts apply to mining. Debt also has its place in mining, and debt is not always the answer, but it can be a useful tool for getting a project from development to operation or to add an expansion to an existing project. A major benefit to debt funding is the retention of 100% equity ownership. Most commonly, if you have a single project, or a smaller project, debt financing is a great option. Debt will provide flexibility in development while allowing the owners and shareholders to capitalize on their project without sacrificing equity. However, there are cases when equity ownership is a better option, like in major operations where capital requirements close in on ten digits and equity value may be one of the only ways to raise capital in quantity significant enough to start the operation. In this section, we will explore debt lending, risk, and the time value of money.
Risk and the Time Value of Money
When evaluating funding options, mining companies need to consider a variety of details:
How much debt has the venture already accumulated?
Will adding more debt pose a greater risk?
What stage is the infrastructure (exploration, development, etc.), and is the infrastructure safe (if an existing mine)?
Is the venture in a politically risky climate?
Does the venture have environmentally sound practices with a solid reclamation plan?
Are considerations for the surrounding communities in play?
Although a short list, it gives an idea of the types of questions we need to ask ourselves before seeking additional funding, especially debt. Adding to this, we need to understand how the time value of money (TMV) will play a role in the project funding and how the project is managed over time. Different stages will require different cash infusions at different rates.
A little background on the time value of money. Essentially, a dollar today is worth more than a dollar tomorrow. This has to do with macroeconomic trends such as inflation, over time. Considering the length of time mining projects take to develop, the TVM plays a crucial role in relation to interest rates, profits, and other investments and guides more informed decisions concerning the money we have today. A project that won’t generate profits for 10 years will look less attractive than a project that will generate cashflows in year 2. The equation for the time value of money is expressed as:
PV = FV[1/(1+r)^n]
Where:
PV = Present Value (what the investment is worth in today’s dollars)
FV = Future value (the value of the investment in the future)
i = Interest (what is the interest rate of the investment. will the money compound or discount?)
n = number of periods (will the investment be compound or discount every year, quarter, month, day, etc.)
From this equation, we can see how the number of periods will impact the present value of an investment. The higher the number of periods (n), the larger the denominator (bottom of the equation), and the smaller the future value of the investment becomes. This effect becomes especially apparent when evaluating the value of mining projects that have cashflows offset well into the future.
For example, the average timeline to get a project from exploration to operational is between 10 & 13 years. Although basic, we can still see how this can impact investment attractiveness as well as the value of the project. Take a project with a net production of 1 million ounces. If that project were to be mined today, all at once, the net value of the investment would be about $861MM dollars after tax and operational expenses. If we move that project out 10 years using a discount rate of 4% (around the average inflation rate) in the same scenario, that $861MM net present value drops down to $581MM. A loss of around $279MM from the effects of inflation alone. This example doesn’t include the impact of the upfront capital required to get the operation into production, either, only the potential revenue from the operation. Starting capital is a value that will negatively impact the present value as it is a negative cash flow on day one (as opposed to a positive cash flow a decade into the future). This is why we generally try to get our investment income as close to our revenue-generating years as possible or minimize our long-term expenses so as to have a lesser effect on our present values.
A lot to consider, isn’t it?
This also brings us to another topic: where does value generation come from in the mining cycle? Great question. In the first few years from project conception, the riskiest years of a project, value is uncertainty driven. If investors see the potential for a significant discovery, the mining company will make a good sum off of a boost in trading (if publically traded), also known as the “sizzle”. The more you can make a project “sizzle” at this stage, the more tantalizing it is for investors, and the more value is generated from the exploration of the project. This is a watered down version of how exploration companies make their money. This period of investment typically lasts around 1-3 years.
Once the project is discovered, this will generally lead to a sell-off from the speculative and risk-driven investors, as the risk from uncertainty-driven investments no longer exists. The project has been drilled, discovered and now we know, for the most part) what is there. The next stage of investment comes after the excitement of discovery has worn off and institutional investors step in to drive development. This is known as the risk-stage, where the capital costs of starting the investment are being pitted against the project merits. Values rise with the quantity of investment as a reflection of confidence in the asset and the company has cash to work through development to get the project into operation.
Once in operation, the risks have mostly been removed and the stock price will start to level out following production where returns on investment will come from dividends on the operation as opposed to risk or uncertainty driven excitement. From this point the risk comes from
In essence, the timeline from start to finish with risk encompasses:
Exploration Risk
Technical Risk
Funding Risk
Price fluctuations
Each aspect of risk comes in at different points along the lifecycle of a mine.
Let’s dig in to some details for risk. Both TMV and risk are important factors for investors and lenders. It is especially true in the natural resources sector. The amount of capital needed for a project and the project’s associated risk both impact investor decisions. The risk that plays the largest role in these decisions is as follows:
Location and Political Risk
Mineral deposits are found across the globe, that said, governance dictates extraction. Governance you ask? All countries are sovereign and can control how mineral resources are explored for, who gets to own these projects, how extraction will be performed and who benefits monetarily. Lenders consider the risk of investing in a project partially based on what the location or region the project is situated in and the political climate dictating exploration, mineral rights, and day to day functions of the operations.
Leadership and Management Risk
By nature, mining is a risky business. Having strong management provides a sense of security for lenders and investors. The reputation of the company and the company’s ability to support strong management of the operations is crucial.
Production Details & Technical Risk
Some technologies are more simple or more proven than others. Proven technologies and practices generally carry less risk in mine design and mineral extraction. For example, open pit operations are less risky than underground operations, by nature of the technology and practices involved. Open pit operations are simple and straight forward (most of the risk here is in scheduling or day to day operations). Underground mine production carries a slew of other risks; was there a mistake in the location of the production shaft? Was the underground mining method chosen efficient and effective, or was there a better choice? Risk of ground failure, need of strong designs, and tight spaces generally lend to more safety costs. All these choices impact production and can add to the technical risk.
Lenders and investors require a solid plan that clearly outlines timelines for certain milestones in development or production. If these timelines are not met, there will be risks of repayment, penalties or a retraction of funding. Adding an additional facet to the technical and production risks. Lenders will consider things like necessary infrastructure, how close the project is to that infrastructure, and the costs associated with developing site infrastructure such as: power lines, access to fresh water, roadways, railways, and other forms of transportation.
Governments also consider infrastructure in permitting and negotiations. Some locations globally may require the mine to add value to local communities through the improvement of local infrastructure or utilities. Adding yet another layer to the technical and production risk category.
Technical and production risk encompass the post-mining activities as well. Even if a site has an outstanding deposit, what are the environmental concerns? Can they be mitigated? Concerns over environmental protection are a large part of the conversation in the US and globally where technical risk can have an outsized impact on the potential outcome of a new project.
Market value of the Mineral / Price Risk
Price risk is something I see as relatively unique to mining (or farming and ranching), where the product produced has a set price. As opposed to manufacturers who more often than not get to set the price of the goods they sell, mining companies are exposed the market fluctuations. Changes in market demand, physical supply, inflation, and a plethora of other economic factors, put commodities companies at the mercy of the market. That said, the lower cost of production, the better chance a company has at surviving cycles of low commodity prices and thriving in times of high commodity prices. It also impacts the type of mineral being processed. For a low-value mineral like copper, a drop of a few cents in the commodity market can put a company out of business, whereas in precious metals a fluctuation of 10’s or 100’s of dollars in one direction or another may be the difference in closing an operation or making a significant dividend.
Financing (Debt)
Once an investment has been analyzed, the type of financing is considered. Generally, there are two main types of financing:
Equity Financing
Investors
Mining Equity Markets
Joint Ventures
Debt Financing
Commercial Banks
Private Lenders
Equipment leases, etc.
Both debt and equity financing carry similarities, the basic framework of which is:
Contract Granting Rights
If it isn’t explicitly stated, its omitted or open for interpretation
Negotiation of Terms
Contractually allocate risks established during due diligence
Due Diligence
Know what you are getting. You are responsible to review and understand the terms of the contract
There are several key components of debt financing that stand apart from equity financing. Most basically, financing a project with a loan is considered debt financing. Money is borrowed and must be paid back, with interest over time. The facets of debt financing are as follows:
The structure of the loan
Payback periods, time value of money, interest rates and the sort will be evaluated when determining the structure of the loan
Security
What will be held as collateral in securing the financing?
Issues specific to land owned by Indigenous Peoples
Social impact of mining on Indigenous lands. Legal interest and ownership of land and minerals must be considered
The structure of a loan can take on a few distinct forms. Again, the loan structure is a function of the interest rate, payback period, terms, and risk as well as other details unique to the purpose and type of loan. Some examples of these loan structures are:
In mining, it will be uncommon to see recourse financing as this type of finance is most suited to things like auto loans or personal loans where the principle is a quantity that can more easily than not, be recovered by the lending agency. In the case of mining, due to the sums involved, construction loans and limited recourse financing are the most common sources of loans.
Construction loans are structured as to provide the lender either debt or equity in the project. The amount will be agreed upon and explicit, although concessions may be made for additional capital. There will be details for the uses of the funds, with a certain level of detail as to accurately account for where the capital is being spent on the project (again, no new ferrari’s (unless you have a clause for it)). Construction loans will also require a security (generally the project itself), as to back the loan in case of borrower default. These loans carry terms, and these terms are another negotiated aspect detailing how long the project will take to complete, what the milestones will be and when the loan’s principle will be paid back in full. Finally, construction loans will have completion tests. A completion test will validate the completion of the project the construction loan was for; if there are multiple parts of the project the construction loan was for, each portion will need its own completion test.
Limited Recourse Financing is another popular form of finance in mining. In limited recourse financing, the amount can include the principle from the construction loan. More often than not, there will be a mechanism (either time or milestone based) that will convert a construction loan into a limited recourse loan. These limited recourse loans will also require security (collateral), and will contain covenants. These covenants can be either NEGATIVE (you can NOT use this capital for XYZ…) or AFFIRMATIVE (you CAN use this funding for XYZ). Covenants are a way to ensure the use of capital as the lender sees fit and as negotiated by the borrower. Finally, limited recourse financing will carry defaults. A default sets limits on what the lender can seek recourse for. For example, if a LRF loan is taken out and the borrower goes bankrupt, the lender may seek recourse up to the default amounts (another negotiated amount), but may not be able to receive recourse (repayment) of the full amount. These loans typically fall in the interest rate of 5-10% for loans up to $100MM.
Loan Security
With most any loan, there is a need for security. Security being the collateral that “secures” the loan. The purpose of this security is to reduce the amount of risk the lender is exposed to in the event the borrow cannot repay the loan. Securities can be both tangible and intangible, meaning they can be physical like real estate (you can touch it), or they can be intangible like a patent on an invention or process (intellectual property). The types of securities lenders might require are:
Personal Property
Tangible
Inventory
Heavy Equipment
Office Equipment
Intangible
Securities
Intellectual property
Accounts Recievable
Permits
Mixed (acts as both personal and real property)
Real Property
Fee Land
Surface and Mineral Rights
Patented Mining Claims
Unpatented Mining Claims
Federal Mineral Leases
State Mineral Leases
Mixed Property (acts as both personal and real property)
This list is mostly pertinent to mining, but these securities can be used across the business and lending spectrum to secure loans. If it has value, it can be used. On top of this, a lender needs to determine what security for the loan. This is typically done through:
A security agreement is (as it sounds) an agreement that “reasonably identifies” the collateral to be used as a security interest. In other words, it will describe the collateral to be used (i.e. a certain piece of heavy equipment(s), a certain patented or unpatented mining claim, etc.).
An Account control agreement is a three-party contract between 1) The Account Holder 2) The Creditor 3) The Lending Institution. In this agreement a moderator (most often the creditor) will ensure the secured assets can not be removed from the agreement in the case of bankruptcy to ensure the lending institution may recoup some portion of their losses in case of default. Mutual funds use ACA’s to post collateral, where, in case of their insolvency, there are assets enough to cover their obligation to the account control agreement (pledgors or owners in the fund).
Pledge agreements (or security agreement) are a two-party contract between a creditor and a debtor. The creditor receives security interest in the loan through “certificated securities by possessing certificates”, or simply put gains equity ownership or voting rights in the company they are lending to (the debtor). This type of agreement also comes with stock transfer powers, where the creditor may, upon receipt of the equity ownership, transfer their ownership as they see fit.
In conclusion, the world of debt ownership is a little more complex than I had previously thought. Although I had some background in it (we’ve all bought cars or houses, right?), there is much more than happens behind the scenes and there a wide variety of ways loans can be structures with an even wider array of securities to back them. For the most part, in mining, we see projects and equity ownership (ACA) as the most common security used against loans. We also see the difficulty mining companies can have in securing a loan given the demands of the time value of money in lending. If the company cannot post a rate of return high enough to combat direct market investment, they won’t be able to secure funding. Hence why the timing of the project can be so crucial in bumping up the net present value of the project and the timeframe to loan repayment.
Best of luck to anyone seeking debt funding for their project. I’m currently on this path and it has been a long road to understand, digest and succeeded in.
