Mining is not a terrain private equity normally digs into.
Volatile commodity markets and unpredictable returns, along with high capital expenditure requirements and long lead times, have acted as deterrents for mainstream buyout groups who need to generate cash flow quickly. The space can also be fraught with political and operational risks, which few buyout groups are willing to take on. One fund that has risen to the challenge is Appian Capital Advisory.
The London-based private equity firm raised $775m in January for its second fund focused on the mining sector, as it bets that the global shift to a lower carbon economy will squeeze supplies of metals such as copper and nickel. The world’s increasing appetite for electric cars, solar panels, batteries and energy infrastructure to reduce reliance on fossil fuels has driven a surge in demand for these metals, which are needed for batteries and other components.
That also lends some environmental purpose to a fund focused on an industry that is hardly known for its green credentials. The Appian Natural Resources Fund II has already deployed or reserved 45% of its capital and expects to deploy the balance over the remainder of this year, targeting medium-sized assets. For LPs worried about inflation risks, it is also investing in precious metals as a portfolio hedge.
Appian was founded in 2012 by former JP Morgan investment banker Michael Scherb, at a time when traditional sources of capital for the industry were starting to dry up due to investor frustration with the lack of returns from some management teams in the sector.
While at JP Morgan, Scherb, a 39-year-old Austrian national, worked on a number of high-profile deals, including advising miner Rio Tinto against a $138bn unsolicited bid from rival BHP in 2008. Appian’s senior advisory board includes former BHP chief executive, Chip Goodyear, and ex-CFO of miner Xstrata, Trevor Reid.
Private Equity News spoke to Scherb about the firm’s strategy, where it sees opportunities for growth and how it navigates the challenges of investing in the metals and mining sector. (Interview has been edited for space and clarity.)
PEN: Private equity has traditionally stayed away from the mining sector and its unpredictable cash flows. Why has Appian chosen to focus on it?
Michael Scherb: We chose to focus on the metals and mining sector nearly 10 years ago, as we saw a highly inefficient sector with very solid demand, and surprisingly little to no competition. Commodities are in everything around us, but it is broadly avoided by nearly all traditional forms of financing because those groups aren’t able to price in the risk/reward proposition as easily as they are in other sectors.
Mining also has a great ability to positively impact the ESG [environmental, social and governance] agenda. For every job created, there are an estimated three to five others created indirectly in the neighbouring communities. We also invest in training, education and health via the Appian Way Charitable Foundation, which has generated 11,000 jobs so far.
PEN: Where do you see opportunities for investment?
MS: Most mis-priced opportunities and the ability to apply technical arbitrage are found a couple years before production. So we don’t take on exploration risk, but focus on investing at the point in time where the asset is technically de-risked, having already been studied and analysed for seven to 10 years.
We typically invest $100m to $300m of equity per project and look for low-cost projects with low capital intensities, as a margin of safety against the commodity price and any unforeseen technical challenges.
We have offices across five continents, but only invest in geographies where the risk we take on is sufficiently compensated, and there are many places we simply don’t invest. Latin America accounts for 60% of our allocation, with the balance split mainly between north America and Australia.
PEN: What’s driving investors’ interest in metals and mining?
MS: Both of our funds have been heavily oversubscribed, but there has certainly been a large increase in inbound interest from LPs from all around the world. Every single one of them is looking at how to get exposure to the shift towards electrification that is taking place. Although renewables and other sources provide exposure, they may struggle to match the returns on offer in the metals and mining sector.
Many LPs also tell us that they are seeking a form of inflation protection hedge, and they understand that mining is the first piece of the industrial production chain and miners pass on every dollar of cost increase because society has to acquire their product no matter what.
However, we will only partner with groups who are able to see through many cycles, as we do not want to insert pro-cyclical pressures into our investment model.
PEN: How are you tapping into the shift to cleaner energy and decarbonisation?
MS: Around four to five years ago, we invested 70% of our fund into energy transition commodities. We did an inordinate amount of work around potential future supply, including speaking to those working at the world’s major copper and nickel mines, to better understand capacity and other bottlenecks to production, and we simply could not see how the sector was going to respond to what we saw as an inevitable move to decarbonise. Our research even involved buying a Tesla and taking it apart to understand the core components!
We acquired a large nickel mine out of bankruptcy and we spun out a copper/gold project out of a listed gold company, and also co-invested into a rare earth project alongside the IFC World Bank. We then quietly went about our business installing a management team and a deep operational plan and now employ more than 4,000 people at these projects, which are expected to generate a very attractive return for our investors.
PEN: What’s the outlook for the mining sector? Is there a supply and demand issue?
MS: The outlook for the mining sector is as strong as it has ever been, with demand for commodities that facilitate electrification and battery storage helping drive activity. An energy system powered by clean energy technologies needs significantly more minerals, such as lithium, nickel, cobalt, manganese and graphite for batteries, rare earth elements for wind turbines and electric vehicles motors, and copper and silver for solar panels.
Theoretically there is no shortage of mineral resources, but the industry needs the right prices to incentivise development of those resources, and even then the long lead time for mines means supply could struggle to keep up with demand.
PEN: How do you operate and manage mines? What sort of expertise do you need to invest in this sector? How has your team evolved?
MS: Appian is unique in that it has the capability to actually run and operate mines in-house. We simply do not outsource technical diligence capabilities and this is all by design from inception. We are now nearly 50 investment professionals overseeing 5,000 personnel on five continents; however the pace of growth has been steady and measured.
Over the last nearly 10 years, we have focused on becoming an operating investor and have developed some proprietary principles to enable us to do this. In addition, all employees invest significant amounts of capital into each fund which aligns outcomes with our investors.
PEN: The typical long-term investment horizon associated with mining can be challenging for private equity. How have you overcome this?
MS: Our fund length is the same as the large PE houses, but if you are investing a couple of years before production, you ultimately want to sell after showing 6-12 months of solid production, so a 3-5 year hold period should be adequate, which fits into a traditional fund life.
There is an argument however, for a strategy of buying long life assets stretching over 20-30 years and simply streaming cash flows back to investors over the duration of that time via an evergreen fund structure, because you may have a great asset, but it would be silly to be forced to sell it for a lower return only because of your fund structure. The fund targets internal rates of return of 20-30%.
PEN: Given the volatility of the mining industry, can you add the same levels of leverage to mining investments that you would to a typical private equity deal?
MS: It’s true that the traditional leveraged buyout models simply don’t work in the mining sector as you can’t lever against the commodity price, so we acquire control through equity. But you can bring in leverage at the asset level to construct the operations.
Mining actually has some inherent advantages which may not be obvious. For example, the phased nature of development actually means that you don’t need to extend large amounts of capital upfront as you earn-in to a project by building out the team, drilling, doing more study and environmental work.
The largest amount of capital to extend is the construction equity alongside the project finance. If you can fully price in the various risks, and have a real handle on the operational side, you can deliver outsized returns to your underlying investors, but it is an extremely tailored strategy, not suited to the DNA of large PE Funds.
PEN: There are a myriad of risks attached to mining assets, including political and operational risks. How do you navigate these?
MS: We have a detailed four step investment process whereby we look at the risk/reward factors of technical risk and financial risk, as well as the softer elements such as management, ESG, permitting, country etc.
We also avoid the types of binary risk that got the first wave of PE Funds in trouble, such as relying on infrastructure, financing, permits or not analysing exit scenarios well enough. The risk we take on is operational, and it is a risk that we can control and mitigate.
This article was published by Private Equity News.
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