• Part I: Introduction
• Part II: Multiples
• Part III: Credit

Mining credit is interesting because of the capital intensive and cyclical nature of the business and unpredictability of cash flows. Capital structures with high leverage are pretty common amongst players in the space. Since commodities as a whole are at the mercy of global supply and demand mechanics that can change very quickly for a variety of reasons, the amount of debt that gives comfort to a credit investor is much lower than that of a less volatile business. The following are some factors that investors should look at before lending credit to a mining company:

Scale

Mining companies with global operations and knowledge, effective logistics, and access to latest technology are likely to be better positioned than junior and intermediate miners to access credit. These companies have multiple streams of cash flow and the ability to sell off non-performing assets when things are going not going well, giving them the ability to access credit more easily. Examples of such companies include BHP Billiton, Glencore, and Rio Tinto.

Diversification

Companies that have a variety of outputs from their operations are likely to have lower cash flow volatility as better performing metals in the portfolio can help sustain a lossmaking unit when its cost curve is above the commodity price, but should be well positioned after consolidation

Position on Cost Curve

Companies that are lower on the cost curve have much larger room for the commodity price to fall before they fail to meet their return hurdles. They also have greater operational flexibility and thus can resort to aggressive pricing tactics to increase production.

Quantity and Quality of Reserves

Cost of developing assets and making them ready for production is costly and therefore the absolute number for reserve size is important. Longer mine life, higher grade ore, and lower cost of separating the saleable commodity all speak to the quality of the reserve and determine a firm’s position on the cost curve.

Consumers

Having a diversified consumer base is important to ensure steady demand for the commodity. A concentrated consumer base is dangerous as many miners have seen in the case of their heavy dependence on China as a consumer of mined products.

Bank Debt vs. High Yield Debt vs. Revolver

Bank debt is secured and senior to high yield debt and thus has a lower interest rate than high yield debt. High yield debt is unsecured and subordinate to bank debt and therefore requires a higher interest rate to compensate investors for the higher risk of default. High yield debt is often necessary to increase leverage levels beyond that which banks and other senior investors are willing to provide. The interest rates for bank debt are usually also floating based on LIBOR plus or minus some premium or discount depending on the credit worthiness of the borrower. High yield debt on the other hand holds a fixed interest rate. Bank debt usually has a shorter tenor and typically requires full amortization over a 5 to 10 years period, whereas high yield debt has a bullet maturity, where the entire principal is paid off in the end.

High yield debt provides a company with greater financial and operational flexibility through incurrence covenants, as opposed to maintenance covenants for bank debt. Incurrence covenants prevent a company from doing something (For example – cannot take on more debt for the next 2 years), whereas maintenance covenants require the borrower to maintain a certain level of financial performance (For example – DSCR should be greater than 1.5x).

Both bank debt and high yield debt have different features and characteristics. Managements often try to use a mix of both types of debt to best fit their strategy.

Companies also use another form of senior bank debt known as “Revolver”. A revolver is a form of bank debt that acts like a credit card for companies and is generally used to help fund a company’s working capital requirements. The revolver has a fixed portion of agreed upon money that the company can access as needed to meet its need. Only the drawn upon portion of the revolver is incorporated into the company’s total debt. There are two costs associated with revolving lines of credit: an undrawn commitment fee and the interest rate charged on the drawn balance. The interest rate charged on the drawn amount is typically the same as the interest rate on regular bank debt.