Mining royalties as an asset class within pension fund portfolios

Written By: Anthony Yadgaroff Chairman Allenbridge Investment Solutions

In recent years major UK pension funds have shown a growing interest in asset classes other than marketable securities, as a means of diversifying their portfolios to reduce volatility as well as helping to match their assets to the longer-term nature of their liabilities. Property and private equity have long been important components of many large pension funds, typically accounting for around 10-15% of assets. Investment in infrastructure and commodities – often through pooled fund vehicles – has emerged over the last 10 years or so, and today typically accounts for around 3-5% of invested assets.

One sub-class of alternative investment that has not been exploited so far, and indeed not really explored, at least by UK pension funds, is mining royalties. This is a little surprising because mining royalties combine many of the characteristics that pension funds are looking for. They are long-term assets with a typical life of 5-15 years (but the life of some larger projects can range up to 25 years or more). They have good visibility of earnings. They provide exposure to commodity prices, but without the exposure to the currently escalating costs of mine development and operation associated with equity investment in mine operators.

What are mining royalties?
A mining royalty is an entitlement to an agreed percentage of the sales revenue of a mining project, without any liability for production costs. There are various definitions of sales revenue, but perhaps the most common one is Gross Revenue (or Net Smelter Return) which is based on the gross sales price of the actual minerals mined. Most royalties endure for the life of the resource and are paid on a regular basis, typically quarterly or half-yearly.

There are two main routes for acquiring mining royalties. The first is where companies specialising in mineral royalties may provide initial finance towards the cost of progressing a mine into production in return for a subsequent royalty when the project comes on stream, perhaps three or four years later. From the mine developer’s standpoint, royalty finance is an alternative to borrowing funds or raising equity. At times when bank credit is in short supply and equity markets are depressed, royalty finance can be an attractive option, especially to smaller mining companies keen not to dilute their equity.

The second royalty acquisition route is to buy a royalty from an exploration company which has retained an interest in a mine they helped discover. Once acquired, royalty companies rarely sell their royalty entitlements. Indeed the secondary market in mining royalties is thin.

While the accounting treatment of royalties can be quite complex depending on the particular vehicle for their acquisition, their valuation is essentially based on the net present value (NPV) of the royalty cash flow indicated by the operators mine plans. The discount factor used will reflect in part the royalty company’s cost of capital, but also an assessment of the risks specific to the project.

One major risk for new mine developments is that the developer will not secure the rest of the financing required to bring the mine into production. To reduce the risk of total loss to the royalty company, royalty agreements will often provide an option for the royalty company to be given equity in the developer or an interest in alternative assets, in the event that the project does not proceed. As a project moves closer to production the NPV of the royalty benefits not only from the unwinding of the discount but also from a reduction in the discount factor as the risk of abortion diminishes.

Once mines are in production, the main risks to royalty income tend to be associated with the volume mined and sold, and the price obtained (including exchange rate movements – most royalties in respect of internationally traded minerals are expressed in US dollars). Mining risk can be carefully appraised but cannot, of course, be eliminated. However a shortfall in production in a particular year does not mean a total loss of royalty income; the resource is still in the ground and will still generate royalty when it is eventually mined. As for price risk, commodity prices have tended to outstrip general inflation over the longer term and, as the cost of developing replacement mines and associated infrastructure tends to rise over time, this seems likely to put continuing upward pressure on supply costs, and hence mineral prices. The volatility of commodity prices in the short/medium term is a concern to many investors (though perhaps less so for investors with longer-term horizons like pension funds). However, because the income of most mines is largely based on contract prices negotiated annually (and in some commodities prices may be settled on an even longer-term basis), mining royalty income is usually subject to less short-term volatility than direct investment in commodities where prices are more closely geared to spot markets.

Barriers to overcome
If mining royalties are potentially so attractive to major long-term investors, what are the obstacles to their development as an asset class within pension fund portfolios?

There is first of all a lack of awareness and understanding of mining royalties – their investment characteristics and their risk/return correlation with other asset classes held by pension funds. The investment advisers to pension funds need to be engaged, research carried out on the historic performance of mining royalties, and analysis undertaken of how they would fit into wider pension fund portfolios.

Secondly, the current volume of investment in mining royalties is still quite small. Taking the major quoted royalty companies in North America and the UK, the total value of royalty deals announced in 2011 was under $1 billion and much of this was focused on gold projects. The figure for 2010 was under $500 million. Undoubtedly the volume of deals was affected by worldwide credit constraints and falling stock markets which affected the ability of both mine developers and royalty companies to raise funds. The underlying interest of small- and mid-tier developers in tapping royalty funding nevertheless remains strong. If pension funds chose to allocate funds for investment in mining royalties, there is unlikely to be any shortage of attractive opportunities.

Thirdly, although the management of royalties in place is a relatively straightforward administrative operation, the negotiation of new royalty deals is a highly skilled process requiring a deep understanding of the various metal markets and an ability to identify the mining risks associated with specific projects, and there are relatively few royalty companies investing worldwide and across a range of different minerals. In North America the major players are Silver Wheaton, Franco Nevada, and Royal Gold, but they are all primarily focused on gold and silver projects. In Europe the only significant royalty company is the London-based Anglo Pacific Group. Anglo Pacific’s market cap puts it just outside the FTSE 250. Its royalty portfolio includes coking coal, iron ore, and uranium as well as gold, and its current strategy is to continue to add to this at the rate of three or four new royalties a year.

Pension funds are therefore currently able to get indirect exposure to mining royalties through investing in quoted royalty companies. However the share price of royalty companies moves up and down for many reasons other than the underlying value of its royalty investments and it would be understandable if pension funds preferred direct investment in royalties under a specialist manager. Much of current pension fund investment in other alternatives is handled through pooled funds and there seems no intrinsic reason why the same model should not be followed for mining royalties.