Australia mining: Swings and roundabouts

Australia's mining industry is on the brink of its biggest-ever hangover. For the last decade - even through the global financial crisis - commodity prices have continued to push upwards. This was driven not only by the resource demands arising from China's infrastructure spending binge, but also a global easing in monetary policy that sought to stimulate business in the wake of the crisis. 

According to the Reserve Bank of Australia commodities index, prices of non-agricultural commodities - which include base metals such as iron ore, copper and gold as well as bulk commodities such as coal - reached an all-time high in 2011 of $111.9 while base metals peaked at $152 in 2007.

This so-called commodities super-cycle set mining companies into a frenzy of activity. Australia witnessed its biggest mining boom since the gold rush of the 1850s and 1860s; a boom which saw an estimated $650 billion of investment flood into the country.

"In Australia the cost base of the industry got wildly out of control," explains Andrew Parker, a partner with PricewaterhouseCoopers (PwC) in Sydney. "Most miners were just digging it out of the ground as fast they could to ship it off to the markets, and so understandably cost was never a consideration in that sort of environment."

Now the party has come to an end. Commodity prices have fallen dramatically since their respective peaks over the last decade: copper prices are down 35%; iron ore prices have fallen 40% and gold prices have tumbled 36%. The mining industry is beginning to suffer the consequences of its earlier excesses and - as commodity prices have return to pre-2006 levels - cost considerations have returned to the fore.

As the dust settles, the question is where does private equity fit into this new normal. Has the fall in commodity prices opened up new doors for investment and if so, where?

Broadly speaking, the impact of the commodities cycle has been across three areas: large mining firms that are scaling back their ambitions and divesting non-core mining asset; junior mining companies, many of which have yet to enter production, in dire need of capital to stay in operation; and mining services companies - everything ranging from logistics to equipment rental - that have long been a popular proxy for mining growth among GPs.

According to AVCJ Research, PE investment in Australia's mining and metals sector peaked in 2007 - along with base metal prices - with $1.1 billion deployed across 24 deals. That amount was amount was nearly doubled last year with $2.1 billion invested, but there were just 10 deals.

A large portion of the total came from China Development Bank's purchase of a 40% stake in Extract Resources for $917 million as well as China Investment Corp. (CIC) and Chengdu Tianqi Industry's $853 million acquisition of Talison Lithium - the two of the largest PE buyouts of Australian mining assets to date. 

Headline deals

The headlines deals, however, are divestments by publicly-traded mining majors that have been forced to review their portfolios, resulting in a smorgasbord of high-quality mining assets coming onto market, the likes of which have not been seen for a decade.

"The big miners are looking closely at their more marginal investments and attempting to get out of them," says Paul Espie, founder of Pacific Road Capital Management, which focuses on investment in mining and infrastructure. "Capital is scarcer now and investors expect cash distributions in an industry where there is a tendency to hold on to cash and reinvest it."

The likes of BHP Billiton, Rio Tinto and Anglo American have all gone through a transition of leadership followed by announcements that they would sell non-core mining asset or, in the case of Anglo American, are at least considering it.

BHP is seeking a buyer for its Gregory-Crinum coal mining operation in Queensland as well as for its aluminum and nickel divisions. Rio Tinto has agreed to sell its majority stake in the Northparkes copper mine in New South Wales for $820 million to China Molybdenum and is looking to offload its Clermont and Blair Athol coal projects in Queensland. More will follow.

What sets this opportunity apart is that these assets have garnered attention not just from strategic investors but from generalist PE firms too. Prior to being sold to China Molybdenum, Northparkes was said to have drawn bids from both The Carlyle Group and KKR.

KRR has made no secret of its interest in acquiring Australian mining assets and already counts former Rio Tinto CEO Leigh Clifford among its senior advisors. While there is yet to be substantial deal flow, a number of industry participants expect big-name GPs to become active in mining.

"If you asked me 12 months ago, I would have probably said that in the main it was only specialist PE funds interested in mining assets, but we are seeing increasing generalist activity and it is very serious inquiry," says PwC's Parker. "They are putting serious resources into processes and working hard to make sure they have the right skills and expertise in place."

However, deals available to private equity in this space are likely to be limited for a number of reasons. Firstly, the mining majors are not in financial distress, so they are under less pressure to sell assets at the kind of fire sale prices many PE investors might be looking for.

Secondly, private equity firms face stiff competition from strategic investors that, more often than not, are willing to a price that are beyond the comfort zone of most pure financial players. A strategic justifies this premium by virtue of the synergies it can offer with its existing assets, and these often appeal just as much to the sellers. PE cannot bring this to the table. Sources familiar with the transaction say this was a factor in the Northparkes deal.

Overseas strategic investors, in particular, have been keen to snap up Australian assets. According to Thomson Reuters, inbound M&A in the mining sector stood at $9.4 billion across 149 deals last year - 32 of these involved Chinese acquirers, which accounted for just under 20% of total transaction value.

However, even after valuations and competition are taken into account, some still question the relative attractiveness of the assets on offer when there may be better opportunities further down the food chain.
"While it might be tempting for large PE firms to buy divestments from mining majors there is one thing you should never forget," says Bert Koth, a director with Denham Capital. "When a large mining company sells something it is often because it doesn't think the asset is good enough. The majors aren't cash constrained so they wouldn't sell high-quality assets. "

Koth argues that junior mining assets offer a far better for proposition PE investors. Most of these companies are engaged in the exploration phase where the risks are much higher and the need for capital expenditure is greater - accordingly, many were badly hit when commodities prices took a plunge.

Private equity investors - typically specialists - have a long-standing appetite for junior miners. Extract Resources and Talison Lithium both fall into this category, while Hong Kong-based Sprint Capital made its first foray into

Australia last year, investing A$36 million ($36.4 million) for a 25% stake in junior mining company Stanmore Coal.

"The middle market - the development capital side - is where things have been tougher but that is where the opportunity is because banks aren't lending there," says Nick Powell, a senior partner with Hong Kong-based resources PE firm GEMS. "The capital markets aren't financing these projects so private equity is one of the few sources of capital remaining."

Boston-headquartered Denham has been closely following this opportunity, having opened its Perth opened last November. Koth makes the point that early overconfidence from investors in the junior mining space had led to many junior mining companies being put on the public markets irrespective of the underlying asset and whether the management is high quality or low quality. There can only be a limited number of winners and so many companies have been over-promoted and ultimately failed to live up to investors' expectations.

As a result, junior miners no longer have the capital to progress their work programs and are instead spending what money they have left on maintaining the salaries and office space to keep operations going - this has had the effect of aggravating shareholders even more, leading to the further falls in valuation. All these elements have contrived to create an environment in which junior miners' need for capital has reached the point of desperation.

"It is not a joke when I say we had to put a password on the elevator at our Perth office to prevent guys from junior mining companies that are running out of cash coming up to our floor," says Denham's Koth, adding that competition for these assets ranges from small to non-existent. "If you know who to speak to it is matter of pick and choose and name your price - I have never seen anything like it in the last decade."

However, while the opportunities may appear abundant it still begs the question: Should direct investments in mining asset be left to specialist PE shops or is it there an opportunity for generalists? The consensus seems to be that generalists should tread carefully if at all.

"It is a difficult space for PE as you have volatile output and on top of that you have single mine risk which can be very challenging," says Justin Reizes, head of KKR Australia. "If you have a broader portfolio it makes things easier but it's still not so straight forward. A lot of people are trying to get their heads around it to see if it makes sense."

An appealing proxy

For many generalist PE firms, investment in mining services still represents the most attractive option. While some have been impacted by cost-cutting across the industry, others say that the commodities downturn has brought the benefits into sharper focus.

Pacific Equity Partners (PEP), for example, backed two companies offering services to Australia's mining industry: on-site support services company Spotless, which was taken private last year for $723 million; and remote power provider Energy Developments, which PEP picked up for around $130 million in 2010. The mining industry accounts for 20% and 50% of each business, respectively.

"The nature of the mining boom has sometimes been a little misunderstood - there is a sense in the popular press that it is all over but that's not really true," says David Grayce, managing director at PEP. "The commodity pricing signals stimulated a classic investment response - mining majors got to work building the next stage of the industry, whether it was opening up new areas like liquefied natural gas (LNG), establishing new mines, or de-bottlenecking infrastructure."

He argues that production volumes have consequently begun to pick up on the back of all the investment and so businesses with exposure to this have been reasonably well placed relative to the cycle. For example, Energy Developments supplies power to major miners on a long-term contracted basis. As miners expand volumes they typically become more energy intensive, demanding more power capacity.

KRR's Reizes observes a similar trend on the services side, but adds there is also an opportunity in helping miners that have been forced to cut back.
BIS Industries was established in 2006 after KKR paid A$1.83 billion ($1.6 billion) for Brambles Industrial Services and Cleanaway Australia - its first acquisition in the country and the largest ever domestic management buyout at that time. The company has been growing its market share in the logistics space by offering a lower cost alternative as mining companies seek to restructure their balance sheets, hire contractors and refocus on their core business.

"BIS is creating opportunities that were not there in the growth cycle by being proactive in helping customers to reduce costs and capital spend," say Reizes. "The company is even providing solutions for existing customers by taking more on-site work but reducing costs for the customer overall."

However, it has not all been plain sailing for the company. KKR put BIS on the block in June last year after negotiations failed to refinance the loans used in the original purchase. It has since obtained a $900 million financing package from Bank of America Merrill Lynch and, with Australia's capital markets looking healthier than before, an IPO is said to be in the pipeline.

Other PE portfolio companies have experienced declining profits and job cuts. These include equipment hire outfit Coates Hire, which is owned by The Carlyle Group and Seven Group Holdings. The investors obtained A$1.85 billion in refinancing last year and announced in June that they had decided against pursuing an exit - Carlyle's investment dates back to 2007 - after an assessment of trade sale options failed to deliver any acceptable offers.

This underscores the fact that, although Australia's mining industry provides no shortage of opportunities, finding the right spots in the value chain remains a challenge. PwC's Parker is convinced that private equity can play an important role; there is demand for capital discipline, cost management and cash flow management skills that are readily applicable from other industries. And specialists can of course offer expertise that goes well beyond that.

It remains to be seen whether generalist interest proliferates or remains limited to the larger players. "The jury is still out," say KKR's Reizes. "There is no doubt that people are focused on it, but I am not sure if many generalists are going to get comfortable enough to stretch into owning mining businesses, particularly when strategics out there also want to own them."

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• Topics
• Australasia
• Australia
• Commodities
• KKR
• Pacific Road Capital Partners
• Pacific Equity Partners
• PwC
• GEMS