Mergers, acquisitions and capital raising
2015 trends and 2016 outlook
A new normal or the bottom of the cycle?
The sector has experienced a decline in deal activity for the fifth consecutive year. This comes as no surprise given the uncertainty over long-term fundamentals and increasing levels of financial distress. However, this distress may be the precursor to recovery in deal volumes — if not value — during 2016.
Management across all levels of the mining and metals sector continue to focus on balance sheet and margin improvement.
Organizations have embraced capital expenditure cuts, mothballing of loss-making operations, productivity improvement and working capital efficiency drives. However, in this market, even these actions are not always sufficient. With internal options exhausted, management are having to make strategic decisions that have long-term implications on the future direction of the business:
We are seeing divestment processes announced across the sector. Anglo American, Nyrstar, Freeport-McMoRan and Glencore have all announced the intention to divest assets in 2016. At a time when prices are depressed, buyers are scarce, and execution risks high, this is a difficult time to be selling.
Balance sheet strength and flexibility are critical in such challenging markets, and there has been an increasing focus to reduce leverage and push out maturities. While there has been some equity raised — and there is likely to be more in 2016 — this has typically been an action of last resort, with Glencore and Lonmin, for example, having to do so in order to stabilize falling share prices. More commonly, debt has been repaid through proceeds raised from divestment, forward sales or streaming.
Going beyond a simple divestment or portfolio resizing, some corporates are literally redrawing their strategic lines. A good example, which was the sectors’ largest deal of 2015 by value, was BHP Billiton’s spin-off of South32, signaling a clear intention to focus on a small number of scalable asset pillars rather than a broad diversified portfolio of assets.
Given the context above, it is of little surprise that dividends are increasingly being forgone in order to retain balance sheet strength. Even among the diversifieds, to which dividend policy is a critical factor in share price performance, we have seen dividends cut and policies change from “progressive” to earnings based, reflecting the realization that future metals prices are inherently uncertain.
Shareholders are increasingly influencing the agenda
Many of the actions witnessed during 2015 are likely to be replicated in 2016 with, arguably, greater regularity and scale.
It is increasingly clear that position on the cost curve is critical as supply-side correction looks to be the only way to restore fortunes. However, with so much uncertainty linked to finance-backed commodity trades, the supply-demand picture is arguably less clear than ever. As a result, the supply-side correction is coming; the question is how much of it will be voluntary shutdowns? And how much will be forced via corporate failures?
The starkest realization of 2015 is that nobody is sure how long the current downturn is going to persist and management cannot sit back and wait for an improvement in market conditions.
Investors are increasingly short of patience, as the dramatic fall in share prices in 2015 demonstrated. There is also an increase in the level of activity from activist shareholders, such as Casablanca (Cliffs Resources) and Carl Icahn (Freeport-McMoRan) who have a track record of instigating change at both the management and the operational levels. Unless equity prices begin to pick up, which seems unlikely in the short term, these investors will continue to circle the industry looking for opportunities to stimulate change and drive value out of challenging situations.
Capital raising continues to be an issue
Overall, capital raised across the sector was down by about 10% y-o-y. The decrease was primarily due to a sharp drop-off in loan finance to the sector, which fell to US$44b in 2015 from US$122b in 2014.
Much of this was for the refinancing of existing facilities, emphasizing the limited amount of new finance going into projects. However, this trend comes as no surprise given the very difficult — and worsening — trading environment that the industry faced during 2015.
The backdrop of challenging market conditions has led to a number of alternative financing strategies being pursued, with asset disposals featuring prominently and almost US$3b of streaming finance being announced across the industry.
Gone are the megadeals with the unashamed focus on consolidating market share. At its 2007 peak, we saw over US$200b of deal value across the sector, with a small number of proposed deals at the time valued well in excess of US$70b. This deal rationale has limited currency in the sector right now; size is not all-important, but instead the focus is on higher returns on capital, greater optionality and flexibility across asset portfolios, and an improved cost curve position.
Key M&A trends that we see continuing into 2016:
Sell-side will continue to be the catalyst for M&A, with assets going to market from distressed sellers in need of capital. This isn’t expected to turn into a mass fire sale, but there is clearly a greater “push” from sellers than a “pull” from willing buyers. The challenge for those divesting is to present the asset properly so that buyers remain confident in the underlying valuation and a competitive process is maintained.
Private capital may well be the new face of M&A across the sector, but it doesn’t yet dominate proceedings and may forever be a relatively small player in the sector’s overall deal activity. Both Magris Resources and Audley Capital demonstrated in 2015 that deals were to be done by specialist funds with a focus on the sector. The model looks more attractive than ever given the relative value of potential targets and the increasingly distressed disposition of sellers. EY expects to see a greater volume of deals completed by these funds during 2016. But, with a significant increase in assets available for sale, only the best assets will attract their focus and pricing will remain disciplined.
Deferred consideration appears to be growing in popularity, while previously it was largely unheard of in the sector. For example, Anglo American has shown it is prepared to consider bids with upside with the sale of Anglo Norte SA and Rustenburg. With increased sales processes, limited buyers and extreme price uncertainty, EY expects to see a greater level of deals incorporating deferred consideration in 2016.
Spin-offs are emerging as a key consideration for the diversified producers. This is perhaps best illustrated by this year’s highest value deal, BHP Billiton’s spin-off of South32, which raised a number of contrasting views on the process. Whether sparked by the South32 process, or otherwise, the idea of packaged asset spin-offs increasingly feature in boardroom discussions. The challenge in a distressed situation is the level of working capital required to go with the spun-off entity in order for it to survive independently; capital that is much needed for both parties and can often be the critical factor in preventing such a deal from successfully completing. Given this challenge, spin-offs are expected to continue to be high on the strategic agenda, but relatively few will actually consummate during 2016.
These have also grown in popularity as companies look to leverage synergies and economies of scale in challenging market conditions. Despite the difficulties, a merger of equals can be successfully structured, as demonstrated by Alamos Gold and Aurico Gold’s US$1.5b combination during the year. On the flip side, as the recent discussions between Randgold and AngloGold Ashanti over the redevelopment of the Obuasi mine demonstrate, getting two parties to agree on the terms of such a deal is incredibly challenging. EY expects to see a greater level of mergers and joint ventures pursued during 2016, with the key focus on derisking and preserving capital; the challenges around execution will remain very high, but an acute need to consummate will drive deals through.
Capital raising in 2016
The financing markets are expected to remain challenging in the year ahead, with corporate rating agencies taking a very close look at future cash generation and corporate refinancing strategies.
The availability of equity will remain an option of last resort only and will be highly dilutive to those looking to raise secondary equity. Now would appear to be the time for well-capitalized producers to look at lending opportunities into the sector that position them for future strategic growth and alternative finance providers to evaluate the opportunities in distress. World-class assets trapped in difficult corporate situations may still provide strong financial returns to the canny investor.