Getting The Deal Through logo
Getting The Deal Through

Global financing alternatives: a primer on royalty and stream financing

Nancy Eastman, Brian Graves and Frank Mariage

Fasken

Thursday 29 June 2017


The mining financing environment today

The past half-decade has been a challenging one for mining companies, whether producers, developers or explorers. Falling commodity prices have restrained revenues, a legacy of cost inflation during the supercycle has kept expenses high, and continued uncertainty in the international economy has made future prospects uncertain. As a result, the availability of financing through traditional equity and debt markets has become constrained and often dependent on brief windows opening when metal prices rise temporarily. Indeed, from 2009 to 2016, equity financings for mining companies listed on the Toronto Stock Exchange or TSX Venture Exchange (being the principal market for mining companies) fell from C$22.2 billion to C$9.3 billion, representing an impressive drop of 58 per cent (TMX Group). 

Notwithstanding these challenges, two broad needs for financing have been evident – the need to generate funding for operations, including new mine development and expansions, and for companies with substantial debt loads (including some of the world’s largest miners), the need to relieve overburdened balance sheets by reducing existing debt. 

Against this background, the focus for many mining companies has been on ‘alternative’ financing options. Foremost among these have been two forms of funding – mineral royalties, which have a long history in the mining industry but which only recently have become mainstream options for generating funding, and metal streams, which are a more recent innovation but have some features in common with royalties. Of course, such alternative financing options remain challenging and somewhat inaccessible in many cases, for early stage ‘greenfield’ projects.

Nevertheless, 2016 was a record-breaking year in many respects in the royalty and streaming sector, which saw the combined market capitalisation of the world’s royalty and streaming companies rise by over US$10 billion to US$27 billion, US$1.7 billion in aggregate equity raises by these companies, and approximately US$1.6 billion in transactions completed (Global Mining Observer). These eye-popping numbers have caused many to observe that such ‘alternative’ sources of funding have now become part of the mainstream.  

This article offers a brief perspective on royalties and streams as financing options – their history, characteristics (including some key similarities and differences) and recent developments, all with a view to understanding what we might expect from them as the industry continues what appears to be a slow and long-awaited recovery. 

Mineral royalties 

The royalty is born

Mineral royalties, which provide generally for periodic payments by a mine owner or operator to a third party based on mineral production over the life of a mine (or sometimes a shorter period based on volume production, for example), have been around for decades but have evolved over the years to meet the needs of the time. Early royalties were often created (i) as a speculative sweetener or upside for a mining company wanting to divest of its interest in a mineral property but not quite ready to give up completely on the property’s potential (known or unknown on the date of sale), or (ii) under a joint venture agreement upon a non-contributing partner’s interest being diluted below a certain threshold level. In each case, these royalties emerged as part of the consideration for the acquisition of rights in a mining property. They did not cost the purchaser anything up front (and remained a challenge to quantify in most cases), but represented additional upside that the seller and any transferee royalty holder could receive. Often the royalty grant would consist of a single paragraph in a lengthy purchase and sale or joint venture agreement. As properties advanced to production and royalty payments were paid, such one-paragraph provisions gave rise to disputes and disagreements about calculating the royalty and the rights of the holder. As a result, more detailed royalty provisions were developed in the relevant agreements with more comprehensive schedules setting out the terms. Today, royalty agreements form stand-alone documents, and it is not uncommon for such agreements to be as lengthy as, for example, an asset purchase agreement to which it is attached as a schedule.

As royalties took on value of their own, they became assets that holders could sell for valuable consideration. With this realisation came the first royalty companies that purchased portfolios of royalties as their main business model. The business models of these early royalty companies involved the acquisition of existing royalties. By 2005 there were several publicly traded royalty companies worldwide.  

Types of royalties

Though a number of different types of royalties exist, most are built on either a revenue-based or profit-based interest in a mining venture. The most common types of royalties are: 

  • Net smelter returns (NSR) – This type of royalty offers an interest in the proceeds paid to the miner by a smelter or refiner. Generally, the only costs deducted from the royalty are those associated with the transportation of goods and the cost of smelting or refining the product.
  • Net profit interests (NPI) – This royalty structure is based on profit after the cost of production is deducted. The specific deductions that will apply are negotiated in the royalty agreement, and vary from project to project. Typically they include operational expenses, such as commercial operation costs and taxes. However, payment of the NPI will often begin only after capital costs have been paid off and the list of applicable deductions is often very diverse, thereby delaying payment (often significantly).  
  • Gross royalties or gross overriding royalties (GR/GOR) – Unlike both NSRs and NPIs, GRs and GORs are revenue-based royalties that do not typically suffer the same deductions as profit-based ones. These royalties are based on the total revenue from the sale of the commodity, with few, if any deductions. 

The evolution of ‘pure’ royalty financings

In 2012 equity capital markets effectively dried up for mining companies and many were forced to look at alternative sources of financing.  The needs of the time had changed and royalty portfolio companies reacted quickly. The next natural evolution to their business model was to purchase new royalties for valuable consideration in the form of an up-front purchase price (some royalty companies even began offering mining companies to pay for the renewal fees of their mining rights in exchange for a royalty thereon). With this development, royalties expanded past being merely part of the consideration in a purchase or joint venture agreement to becoming their own stand-alone financing vehicles. Paying valuable consideration for a royalty naturally meant that the purchaser was in a position to negotiate more detailed terms and increased rights as a royalty holder, for example:

  • What rights did they have to a site visit or audit of the payor’s records? 
  • How the price of the mineral or product was determined and what deductions were reasonable in calculating the payments? 
  • What restrictions could they impose on the operator? 
  • What happened if the operator transferred the underlying mining property?  
  • Could they be granted security for any unpaid royalty payments due to them?

Protecting a royalty interest – royalties under scrutiny

The mining industry for years had an expectation that royalties in many jurisdictions would ‘run with the land’ and therefore survive a transfer of the underlying property, whether owing to a private transaction or bankruptcy proceeding. Royalties that became valuable assets were worth fighting over and led to many courts considering the relevant legal issues. In the Canadian context, in 2002 the Supreme Court of Canada decision in Bank of Montreal v Dynex Petroleum Ltd ([2002] 1 S.C.R. 146) made it reasonably clear that under Canadian law a ‘royalty interest’ can be an interest in land if (i) the language used in describing the interest is sufficiently precise to show that the parties intended the royalty to be a grant of an interest in land, rather than a mere contractual right, and (ii) the interest out of which the royalty is carved is itself an interest in land. Subsequently, court decisions in Canada referred to this two-step test, but because each royalty in question was different, and the relevant laws of each province or territory differed, the analysis sometimes produced different results. In the civil law jurisdiction of Quebec, the Court of Appeal recently declared that ‘civil law is a complete system, and care must be taken not to adopt principles from foreign legal systems without questioning their compatibility with our law’ (Anglo Pacific Group PLC v Ernst & Young Inc, 2013 QCCA 1323). The Court then went on to say, in citing the Dynex Petroleum decision of the Supreme Court of Canada, ‘that word of caution is required because the appellant seeks to indirectly import certain common law notions applicable to mining royalties’ (Anglo Pacific Group PLC v Ernst & Young Inc, 2013 QCCA 1323).    

The important point to take away is that not all royalties are created equal. This is especially true when looking at the way in which courts and tribunals have dealt with royalties in other countries worldwide. Clearly drafting a royalty agreement in light of the laws of the local jurisdiction is an important first step in creating a royalty that will protect the interests of the royalty holder. In addition, as discussed above, several contractual rights can be built into a royalty agreement to give the holder important rights and to subject the grantor to certain restrictions. 

Metal streams

What is a metal stream?

A metal stream is essentially a financing technique structured as a commercial arrangement, namely a long-term contract for the purchase and sale of production from an identified mineral property. As such, in some ways it resembles an offtake arrangement, while in other ways it can be likened to a royalty with some additional features of a debtor/creditor relationship. 

Under a stream, the purchaser (typically a specialised streaming company) is granted the right to purchase from time to time a quantity of metal representing a percentage of production from the mine at a significant discount to the spot market price of the metal, all in exchange for an up-front cash payment that constitutes a deposit against purchases to be made under the stream. As the reference mine produces, the purchaser pays the mining company the discounted cash price for metal purchased (ie, per pound or ounce of product). In the early years of the stream, the difference between the prevailing spot price and this discounted cash price is applied to reduce the amount of the upfront cash deposit; once the deposit is exhausted, the purchaser only pays the discounted cash price for the remaining life of the stream. The stream generally is intended to be a long-term obligation of the mining company, often life-of-mine or for a term of 25 years or more.

Streams are a relatively recent innovation in the industry, with the first such transaction having been entered into in 2004. The majority of deals have traditionally been done by a handful of specialised royalty and streaming companies that have built their business models around this type of financing. However, given the substantial number of large, high-value transactions that have been completed in the past five years, the market has seen a number of new entrants. To date, most streams have been in relation to mines in Canada, the United States and Latin America, although in recent years there have been a limited number of deals completed on assets in Africa, Europe and other jurisdictions. 

Stream economics and flexibility

The economic and commercial terms of stream arrangements are inherently flexible and can be customised to particular circumstances. This flexibility is evident from a number of features of recent streams, including the following.

The commodity being streamed can be the primary product of the mine or a by-product. 

While the first streams were exclusively on precious metals, streams have evolved to apply to a more diverse range of commodities including base metals and even diamonds.

For streams undertaken for the development or expansion of a specific project, the upfront deposit must be used for that project; however, where a stream is on a proven producing asset, the proceeds can be used for any purpose, including to reduce debt. 

The terms of the stream typically do not give the purchaser control over operational decisions at the mine, and they generally do not require the mining company to commit to meeting any ongoing financial ratio tests.

The commercial terms of streaming arrangements need to be carefully structured to achieve the tax planning objectives of the parties, since the accounting and tax treatment of the upfront deposit is often critical to the financial viability of the stream. In addition, for mining companies with outstanding debt that are subject to oversight by credit rating agencies such as Standard & Poor’s or Moody’s, it may be important to ensure that the upfront deposit is not treated as debt or else it may impact on their credit ratings and/or inadvertently results in their being offside their debt covenants. 

Royalties and streams compared 

Though there is no standardised structure for either royalty or stream agreements, there are many similarities which typify both. There are some significant differences to consider when deciding which to pursue.

Similarities

Differences

Upfront payment for future consideration.

Royalties typically paid in cash, streams involve deliveries of metal or metal credits.

Long-term obligation.

A stream provides ongoing cash flow to the producer after payment of the up-front deposit; a royalty does not.

Both can be the subject of a mortgage of the underlying property or other security interest on the project assets, or a parent guarantee.

A stream involves delivery of fungible metal with reference to production from a particular mine, a royalty provides the holder with an interest in actual production from a mine.

Usually no maximum/minimum amounts required to be delivered or paid.

Streams are commodity-specific, royalties can be on all minerals.

Risk/reward allocation is similar, both covenant light for the producer.

Different tax, accounting and rating agency treatment.

Purchaser/holder has little or no input on operational matters at the project.

Royalties are typically structured so as to ‘run with the land’ in the event of a transfer of the underlying mineral properties; it is generally accepted that streams do not.

Recent developments

In the streaming space, one of the most significant development over the past two or three years has been their use by some of the world’s largest mining companies as vehicles to raise funding to repay outstanding debt and ameliorate their balance sheets. In the two-year period from 2015–2016, each of Vale, Glencore, Barrick Gold and Teck Resources sold streams on existing producing assets with up-front deposits exceeding US$500 million. These deals seem to have been the result of these companies dealing with a ‘perfect storm’ of high leverage, tight equity and credit markets and limited alternative disposal opportunities, and as a result this concentration of large deals may not repeat itself any time soon. However, their sheer size captured market attention and had the result of bringing streams increasingly into the mainstream consciousness. 

At the same time, there seems to be a growing appetite among mining companies to insist on provisions enabling the seller to terminate, in whole or in part, its streaming obligations for a premium. This seems to be evidence that miners are increasingly viewing streams as yet another tool in their financing toolbox that can be adopted as needed, but which can also be unwound when markets change and a shift to other financing opportunities begins to look more attractive. 

Looking ahead

As the mining industry begins to slowly recover from the recent turmoil, and with the resurfacing of traditional equity and debt markets, will royalty financings continue to be popular alternative financings for mining companies? Will investors look to creatively tweak the ‘standard’ royalty or look to newer financing vehicles such as streams? While the use of royalties rose in popularity as an alternative to raising funds in the capital markets, they are likely here to stay not as an alternative but as just another mainstream option in the financing packages available to mining companies. 
One way or another, it seems clear that in the current global mining climate, both royalty and stream agreements will doubtless remain key financing options for some time to come.


Back to Mining




Follow Getting the Deal Through for the latest updates on law and regulation worldwide

Follow us on LinkedIn