In Recent times quite a few speculators in the mining resources sector have been touting royalty companies as the best entry point into the world of mining investments. So, are these royalty companies really “hidden gems”, or are the pundits missing something? Let’s first take a look at some of the main investment instruments available in the mining sector:
1. Debt Instruments: here an investor could purchase tradeable bonds in mining companies. These would usually represent the most senior credit claim to the cashflows and assets of the mining companies. In other words, in the ordinary course of business, the interest and capital payments due to bondholders would be made first, and only after these claims were fully satisfied, would the claims of royalty providers, other creditors, or equity shareholders be paid. In practice, the bonds of mining companies can be purchased through brokers, via pension schemes, mutual funds, or via investments in hedge funds;
2. Equity Instruments: These are shares in mining companies, and can be bought or sold on a stock exchange, via a broker. The shares represent a portion of the ownership of the company, and are the most subordinated claim to the cashflows and assets of the company. By this we mean that the claims on the company attributable to shareholders (namely dividends), would only be honoured after all other claims (senior debt, subordinated debt, royalty and streaming etc.) would be met in full;
3. Exchange Traded Funds or Mutual Funds: These are funds that manage a portfolio of investments on a client’s behalf in return for a fee. These funds would provide their clients with exposure to an underlying asset. Exchange traded funds or mutual funds could take any form: from funds offering exposure to a share in a specific mining company; funds offering exposure to a collection of shares or bonds within the mining sector; or funds offering exposure to the price of a physical commodity, among other possibilities. Exchange traded funds or mutual funds would not necessarily need to own the underlying assets that they track. This raises potential ethical and disclosure issues. The main point to realize here is that the performance of such funds may differ materially to what an investor initially thought they wanted exposure to, depending on the performance of the fund managers.
4. Physical Product: in many instances investors would be able to directly buy and store the physical product mined. The investor would take delivery of the finished product, and would then be responsible for the storage of the physical product. This is commonly done for many types of precious commodities, for example: gold, platinum, silver and diamonds;
5. Finally, Royalty and Streaming Companies: A royalty company would provide an upfront cash payment to a mining company, and in return the mining company would be obliged to provide the royalty provider with a percentage of the revenue earned by the mine over a predetermined period. For a streaming company the mechanics of the transaction would be similar, with the main difference being that in return for the upfront payment, the stream provider would be entitled to purchase the production from the mine at a deeply discounted price in future, for a predetermined period.
So what is all the fuss about when it comes to royalty and streaming companies?
Benefit 1: Royalties (Revenue-based royalties) provide investors with exposure to potential upside movements in a commodity. In addition, these royalties are not directly exposed to the risks of rising input costs borne by the mine. In other words, royalties are usually paid to the royalty company based on a percentage of the top-line revenue of the mine. The royalty company would receive the same revenue regardless of whether or not the mine was experiencing declining profit margins due to rising input costs. The royalty company’s return on investment would therefore remain unchanged despite rising input costs, as long as the mine they contracted with continued to operate at anticipated production levels. One should be careful here though. Declining profit margins may cause a mine to decrease its output, or mothball certain loss-making operations. Due to the relatively high cost of doing so, mining companies would typically view cutting output as a last resort. However, royalty companies would be adversely affected by declines in the output of mining companies, and would typically have no rights to intervene in the mining company’s decision as to whether or not to decrease production (whereas equity holders would have the ability to intervene).
Benefit 2: Royalty companies don’t need to employ large technical and operational teams to manage the day-to-day operational tasks associated with mining. The royalty companies are a step removed from the operational issues of the mine, and for this reason their employee overheads are much smaller than those of mining companies. The royalty companies however, still enjoy the same commodity price exposure as the mining companies. Again, one should be careful here. Just because the operational issues are not directly borne by the royalty company, does not mean that the royalty companies are immune to operational risks. Royalty companies are merely a step-removed from such issues, and have no say in the day-to-day operational decisions of the mine. If the mine was to experience technical breakdowns resulting in losses of production, both the mine and the royalty company would suffer.
Benefit 3: Royalty companies are usually not as heavily regulated as banks, and would not need to comply with the same risk frameworks that banks would need to comply with. For example, Basel frameworks and other country-specific reserve requirements, may limit the level of risk that banks could participate in, but would not affect the risk frameworks of royalty companies. For this reason, royalty companies would often be able close funding deals relatively quicker than project finance banks or bond placements. Project finance banks would typically spend much time on legal and financial structuring to make sure that their funding, collateral, and security structures would be water-tight. A potential pitfall to the relative flexibility and speed of execution of royalty deals would be less stringent due diligence having been undertaken in order to close such deals. Investors in royalty companies would need to look into the portfolios of such royalty companies in order to assess the strength or weakness of the overall royalty portfolios. If the portfolios consisted of many weak or high-risk mining assets, the royalty companies themselves would be considered to be high risk as well (despite potential portfolio benefits from diversification).
Conclusion The benefits of investing in royalty companies are significant, namely: commodity price upside exposure, diversification effects across a large portfolio, and separation from input cost pressures. However, having personally been involved in distressed-debt transactions involving royalty companies, the risk associated with such investments should be thought of as being very close to equity risk. In an all-fall-down situation, the unsecured nature of such facilities would open royalty funders up to the possibility of losing the entire value of their initial investment, with very few rights or recourse to mitigate their losses.
Overall, I do believe that the business case for royalty and streaming providers is a compelling one. In the end, the performance of such companies would largely depend on the strength of their underlying portfolios. If well structured and diversified, the returns enjoyed by royalty companies would potentially far exceed fixed-income instruments such as corporate bonds issued by mining companies. Royalty companies would be somewhat insulated from the risk of declining profit margins, as opposed to equity holders, whose dividends and capital gains are directly affected by operational cost performance of the mining company. Royalty companies may also offer greater transparency than mutual funds or hedge funds. Finally, royalty companies would allow the investor to enjoy direct upside on physical commodities, without needing to be concerned about the
costs of storage of physical product.
Written by Perry Fisher
(Corporate Training | Consultant | The Tauro Group - Fast-tracking the development of professionals in finance) To learn more about funding and investing in the mining sector, download my free e-book: https://www.subscribepage.com/miningebook
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