Denver, Colo. — Most people affiliated with the mining industry know how large a modern project can be. The size and scope, the technical know-how, and even the equipment, all serve as tangible evidence that the mining business has evolved into a highly sophisticated industry.
Though less visible to the casual observer, a corollary evolution has occurred in the discipline of mine financing. Funding the evaluation and construction of mining projects today typically requires one or more of a variety of financial relationships. Equity financing, conventional debt and joint ventures are common approaches, while bonds, convertible debentures, contract mining, toll milling and processing, equipment leasing, royalty financing and others are less typical (or not widely appreciated as funding mechanisms). All have specific advantages, disadvantages, and costs, and may or may not align the interests of the mine operator and the financial partner.
This article will focus on royalty financing, with an examination of its applications and characteristics, how it compares with equity and debt facilities, and an example of a recent transaction involving royalty financing.
What is royalty financing?
Briefly defined, royalty financing involves an agreement between a financier who provides cash (financing) to a mine operator (or exploration company) in exchange for a portion of the future revenue stream from a project or projects (royalty).
Royalty financing can be employed in a variety of situations, including the following:
* early-stage exploration projects;
* late-stage exploration projects seeking financing for prefeasibility and feasibility studies;
* mine development and construction financing;
* mine or plant expansion projects;
* reclamation bonding;
* project or company acquisition financing; and
* financing to restructure debt and balance sheets of projects and companies.
Financing comparisons
In comparison with debt and equity financing vehicles, the ancillary costs of royalty financing are typically much smaller. The cost of money in conventional debt and bond issues and equity financing is commonly much higher when all fees and costs are considered. Royalty financing can also be kinder to the company’s balance sheet. In its simplest form, royalty financing repayment is treated as an operating cost, and is not an obligation, as in debt or bond financing. Therefore, royalty financing also preserves a company’s debt capacity for future or additional opportunities. Royalty financing carries fewer restrictive covenants than conventional debt or bond agreements. Most notably, royalty financing does not typically impose a hedging requirement on the company or the operation, as is more standard with debt financing vehicles.
A further advantage is that royalty financing does not necessarily require extra-project collateralization; it applies only to the project (or projects) of interest. Debt financing may require that a security interest be extended to other assets of the company; bonds extend a claim to all assets of the company; and equity financing, by definition, provides an ownership interest to new shareholders and sponsors in all assets of the company — current and future. Therefore, for shareholders, royalty financing does not result in direct dilution as in a substantial equity financing. Royalty financing stretches payments over the life of the reserve or mine, whereas conventional debt front-loads the project with interest, principal payments and fees. Analyzed from a financial viewpoint, this characteristic of royalty financing enables an operator to enjoy higher cash flows in the near term. As a result, the net present value of cash flows in a royalty-financed project may exceed those of a debt-financed operation.
Shared risks and rewards
Royalty financing also reduces risk by transferring the payment and repayment obligations of conventional debt and bonds (in dollars or other currency) to product-denominated payments. Thus, it eliminates price risk and production and operational risk relative to more rigid debt service structures. The provider of royalty finance, therefore, assumes a share of the various risks involved in the operation; it is equally rewarded with the operator or owner for positive developments, and suffers with the operator in down markets or with negative developments. The interests of the operator and the financing party are much more aligned in royalty financing than in most conventional financing vehicles.
Royalty financing is not permanent. If the projects subject to the royalty financing cease operation, the royalty payment also ceases. By contrast, equity financing permanently alters the ownership of the company, and applies to all assets, present and future, even if the project financed by the equity financing concludes operations. Debt and bond financing may remain corporate obligations regardless of the operational status of mining operations.
A standard royalty
There are no hard formulas employed to calculate the royalty percentage for a certain financing amount. Each project requires consideration of the stage of development, and the risks associated with that project (technical, political, social, managerial, permitting and environmental). For a project in production, or with all permits in place, and with reasonable other risks,
In October 2004, Royal Gold announced an agreement with Revett Silver (a private company 65%-owned by
* In exchange for financing, Royal Gold obtained payments equivalent to a 7% gross smelter return (GSR) royalty from all metals and products produced and sold from the mine. The GSR royalty will extend until either cumulative production of 90% of the current reserves is reached, or Royal Gold receives US$10.5 million in cumulative payments, whichever occurs first.
* Royal Gold acquired a perpetual GSR royalty (perpetual royalty) at the mine for an additional payment, allowing Royal Gold to capture the upside potential on any additional production in excess of 100% of the currently identified reserves. The rate for this perpetual royalty begins at 6.1% and steps down to a perpetual 2% after cumulative production has exceeded 115% of the current reserves.
* In a third transaction, Royal Gold purchased 1.3 million shares of Revett’s common stock for US$1 million. These shares can be converted, under certain circumstances and at the election of Royal Gold, into a 1% net smelter return (NSR) royalty on another mine the company owns.
For current purposes, we’ll focus further discussion on the first two components of the agreement.
As per the first agreement pertaining to the transaction above (the GSR royalty), Royal Gold receives payments based on actual production from the mine, regardless of whether production exceeds or fails to meet the production plan. Royal Gold thereby assumes its share of the risk of production including the ramp-up period to full production, and its interests are aligned with those of the operator. Scheduled payments, such as exist in conventional debt facilities may not provide sufficient flexibility in similar situations, should the operator experience hiccups in the ramp-up or full-production stages. Scheduled payments not linked to production can stress an operation, or worse.
The royalty structure, applied over the life of 90% of the then-current reserves (the 90% limitation results from specific la
nguage in a pertinent U.S. Revenue Ruling), stretch the payments over a more significant portion of reserve life, rather than front-loading the operation with scheduled payments as with conventional debt. The royalty structure decreases the annual payments (subject to metal price changes) relative to scheduled debt service payments, enabling Revett to enjoy higher cash flow in the early years of operation.
The second (perpetual royalty) agreement establishes a “tail” royalty applicable to production — in this case, in excess of 100% of the then-outlined reserves. The terms and structure of this agreement provide Royal Gold exposure to the upside of the project while diminishing the overall magnitude of the royalty position. The tail royalty can be viewed as the potential reward to Royal Gold for providing competitively priced funding without upfront fees, and for sharing risk with the operator, including startup and completion risk, production profile (timing) risk and metal price risk.
The example provided by this transaction demonstrates a typical structure of royalty financing. However, the financing vehicle offers tremendous flexibility in structuring, and can be custom-designed to meet the needs of the operator and each individual project. Royal Gold believes the flexible structure, competitive pricing and risk-sharing attributes of royalty financing provide companies seeking project finance with a serious alternative to more conventional financing approaches.
— Donald Baker is Royal Gold’s vice-president of corporate development. Based in Denver, Colo., Royal Gold is a precious metals royalty company, purchasing existing royalty positions on precious metal mines and projects, and developing royalty interests through financing activities or exploration alliances.
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