Transcription
Hello and welcome back to the Financial Modeling for Mining course. In this lesson, we will review the project finance loans in the mining industry. So, let's begin with a review of the typical project finance structure in a project finance transaction in the mining industry.
The principal players are the sponsor, which is developing the mining projects, and the lender or a consortium of lenders that will provide the debt financing. To raise the debt financing, the sponsor will have to set up a special purpose vehicle or SPV, which will be ring-fenced. Ring fencing is achieved when the SPV has its own board of directors, its own bank accounts, its own financial reports, and accounting.
So, the SPV will be developing the mining project that the sponsor wants to develop by means of project finance debt. The SPV will raise the debt financing from the lender and equity financing from the sponsor to develop the project. The lender will take the assets of the SPV as security, and these assets may include the equipment, processing plant, and mining licenses.
Once the mining project is operational and generating cash flow, it will repay the interest and principal to the lender, and the remaining cash flow will go to the sponsor in the form of dividends. If the project does not perform and the cash flow is not sufficient to pay the interest and principal, the lender cannot go after the assets of the sponsor. So, the loan that the lender provided to the SPV will be on a non-recourse basis because the lender will not have recourse to the sponsor. Therefore, the lender can only rely on the cash flows that will be generated by the SPV and will have recourse only to the assets of the SPV. So, this is how a typical non-recourse lending structure looks like.
Not all mining projects can raise project finance debt, and the availability of project finance loans for mining companies will depend on several factors. First, lenders want to see attractive projects with high project IRR. Lenders are interested in the operating cost structure of the mining project, and they want the project to have a competitive position on the cost curve. Lenders also want to see a long mine life, so there are sufficient reserves to repay the debt. More importantly, they want the mining reserves to remain after the debt has been repaid, and this is called a reserve tail. So, if the debt is not repaid by the scheduled debt repayment date, then these remaining reserves can be used to repay the outstanding debt. So, these remaining reserves will serve as a cushion in case there are problems with debt repayment. Therefore, long mine life with a reserve tail reduces the project riskiness.
Project finance lenders usually finance a mine that produces a liquid commodity. Precious metals and base metals are liquid commodities traded on the commodity exchanges, and there is a significant market for those commodities. So, it is unlikely that a single mine can affect the supply and demand dynamics. However, if the mine will be producing rare earth metals, which are traded privately, there may be market and pricing risks on top of the high volatility that all commodities suffer from. The rare earth metal market is significantly smaller than that for precious and base metals, and the majority of the rare earth trading is concentrated in Asia. So, a new mine that produces rare earth may find it difficult to penetrate the market unless substantial discounts are offered. In addition, since the rare earth market is small, a single mine can upset the supply and demand balance. Therefore, these types of projects that produce illiquid or niche commodities are riskier for the lenders to finance.
Lenders also want to see the availability of the off-take and hedging agreements, since these types of agreements reduce the revenue risk, and whenever possible, lenders will insist that the mine hedges a portion of its output. In the end, lenders want to see what kind of risks the project has and if there is a way to eliminate or mitigate those risks.
So, what we saw when we discussed the project finance structure is non-recourse lending. However, more often than not in the mining industry, the lending is done on a limited recourse basis. The lender will require the sponsor to provide limited guarantees. First, the sponsor will have to provide a construction completion guarantee. For example, if the construction completion is never achieved, the sponsor will have to repay the loan. Next, the sponsors will have to provide performance guarantees. If the performance of the project is worse than expected, for example, once the project is operating, the metal recovery or the ore grade may be lower. If the revenue is affected materially, then the lender may actually require the sponsor to repay part of the loan. The sponsor is also required to provide equity support to the project for any cost overruns. So, if the construction costs exceed the cost that has been agreed upon, the sponsor will have to inject more capital into the project. Essentially, the lenders will have full recourse to the sponsor during the construction phase.
Earlier, we mentioned that to raise the project finance loan, the sponsor sets up a special purpose vehicle, and there are benefits to arrange the project financing in this way. The ring-fenced special purpose vehicle allows the sponsor to raise the loan on a limited recourse basis, and if the SPV is not ring-fenced, in some jurisdictions, the lender may have full recourse to the sponsor both during the construction and operations phases. Ring fencing provides limited liability for the project sponsor. If there is a problem with the project, such as a financial problem or environmental problem, the project sponsor only risks with the money invested into the project. The project company serves as a shield for the project sponsor. The reverse is also true; if there is a problem with the project sponsor, the project company will continue to exist, shielded from the problem of the sponsor. And finally, the sponsor may already be a highly leveraged entity, and therefore, raising more debt on the balance sheet may lower its credit worthiness. So, raising the debt through the ring-fenced SPV will not affect the credit worthiness of the sponsor.