Financing conditions have been tough for miners in the last two years, but metal prices quickly recovered from last year's fall and bank appetite for mining exposure is slowly starting to recover. A couple of eye-catching developments in the first quarter of 2010 offer hints of how mine developments will attract funding over the next 12 months – and much of it may not be bank debt.

In January, Finnish nickel miner Talvivaara paid off its entire project debt by selling the output of its secondary product, zinc, upfront to Belgian producer Nyrstar for $335 million. It was the first deal of its kind and was quickly followed by a large trade finance facility for Nyrstar.

Soon after, Augusta Resource Corporation closed a $230 million royalty stream financing from Silver Wheaton for the silver and gold output of its Rosemont copper mine in Arizona. The pre-payment for the mine's secondary output provides Augusta with funding for 25% of the project's total cost and is the second time that Silver Wheaton has combined a royalty stream purchase with a project financing, after it agreed in September to pay $625 million to Barrick Gold for the rights to 25% of the silver output from its Pascua-Lama development.

Although there are important differences, what the Silver Wheaton deals share in common with the Talvivaara refinancing is that the sponsors all raised capital by selling the offtake of their secondary metal for an upfront pre-payment. This comparatively new financing technique has gained in popularity recently, and it is one of a broadening range of tools available to junior miners as alternatives to pure project finance.

"The banks moved in such a way they made people feel there was no liquidity," says Martin McCann, head of infrastructure and commodities at Norton Rose. "But large trading companies are filling the gap, showing there is depth available in the financing market through other means."

The development comes at an interesting time for the sector, as the developers of many projects that closed in the middle of the last decade are looking to shed the restrictions of their project loan agreements in a refinancing, now that they have graduated from the construction and start-up phase to the operational phase (see box 1).

Juniors reach for the quick silver

Under the terms of Rosemont's pre-pay agreement, Silver Wheaton will pay Augusta Resources $230 million – pending the fulfilment of conditions precedent, including the closing of project debt – in exchange for the right to buy all of Rosemont's gold output at $450 per ounce, and its silver output at $3.90 per ounce. Currently the spot price for gold is over $1,000 per ounce, and that for silver is over $17 per ounce.

With an estimated annual production of 221 million pounds of copper, 2.4 million ounces of silver and 15,000 ounces of gold, Augusta says it is giving up only 5% of the mine's projected revenue in exchange for 25% of the project's $890 million cost. Augusta, which raised C$32 million ($31.5 million) in March through a share offering, aims to finance 70% of Rosemont's cost with project debt, though it has yet to mandate bank arrangers.

Pre-pay streaming deals like Rosemont have been happening for a few years now, but combining them with project finance is a new development. Rosemont is not the first pre-pay/ project finance hybrid, but it is the first where the sponsor is surrendering 100% of the upside potential of its secondary metal stream.

Silver Wheaton agreed in September 2009 to pay $625 million to Barrick Gold for the rights to 25% of the silver output at the Pascua-Lama gold project on the border between Argentina and Chile. As with Rosemont, the pre-pay is a precursor to raising project finance for the $1.5 billion project, which has an estimated annual production of between 600,000 and 700,000 ounces of gold and between 20 and 25 million ounces of silver over its productive life. The price at which Silver Wheaton has the right to purchase the silver from Barrick is $3.90 per ounce, the same price as on Rosemont and most of its 13 long-term silver purchase agreements.

Silver Wheaton is not the only company involved in purchasing mining royalties. The biggest other royalty houses are Franco Nevada and Royal Gold, specialising in gold royalties. Gold Wheaton is another, newer company – founded by some of the same investors that set up Silver Wheaton, with the aim of replicating with gold rather than silver their former company's business model. This consists of forming partnerships with producers – usually of base metals, though Barrick is an exception – that unearth precious metals as a secondary by-product. Other royalty companies typically take a proportion of a mine's "net smelter return" on overall output.

One explanation why this model is proving so successful for Silver Wheaton – turning it from its inception in 2004 into a company with a market capitalisation of over $5 billion – is that it is able to exploit the arbitrage potential presented by short- to medium-term dislocations in financial markets. Silver Wheaton is able to raise capital more cheaply than miners are able to raise debt and hedge their output because it is able to raise equity at a high multiple of earnings, reflecting the option value in the silver price and the fact it does not face any operating risk on a mine. Life-of-mine agreements provide further upside as mines tend to stay productive for longer than is estimated. So the assumption that producers will add further value to the reserve is reflected in the royalty company's share price.

The key to the model's success is maintaining a diversified portfolio that reduces country risk, and ensuring that streams are purchased from mines with solid fundamentals in place. Gold Wheaton has run into some trouble because two of its first three gold streams have been with First Uranium's MWS project in South Africa, which is flirting with insolvency.

Another explanation given for the rise of pre-pays is that producers' willingness to give up the upside potential of their secondary metals correlates to their shareholders' increased appetite for commodity price exposure on their primary source of income. Primary investors often aren't concerned about the by-product of their operation, attributing it only as cash against their operating costs. When it closed its pre-pay with Silver Wheaton, Barrick Gold said the reason it chose a pre-pay was because it allowed it to preserve the benefit of 100% price upside on Pascua Lama's gold output.

All our base belongs to us

Base metal producers, which operate with an even higher risk profile, stand to gain even more by benefiting from the greater certainty under which royalty companies operate. One way in which Talvivaara differs from Rosemont is that Nyrstar, unlike Silver Wheaton, is a metals trader with roots as a zinc smelter still involved in the industrial process – and in need of feedstock. While the downside risk on more volatile base metal prices is greater, the economic logic underpinning the deal is informed by more than arbitrage opportunities. "Traders need security of supply so we are working with some that are looking for opportunities to invest directly in projects," says Judith Mosely, a managing director in mining finance at Societe Generale.

The agreement with Nyrstar means that Talvivaara, in exchange for an upfront payment of $335 million, will deliver all of its zinc in concentrate production until a total of 1,250,000 metric tonnes has been delivered. This allows Talvivaara – primarily a nickel mine, which secured an 8-year $320 million project financing in 2007 backed by a 10-year offtake agreement with Norilsk Nickel for 100% of the main nickel output – to completely repay the original project debt. Zinc deliveries to Nyrstar will occur over a 10 to 15-year period starting immediately. In addition to the upfront payment, Nyrstar will pay Talvivaara a Eu350 processing fee for each tonne of zinc delivered. If the spot price of zinc exceeds $2,500 per tonne, Nyrstar will also pay Talvivaara a small proportion of the difference.

The forward price for Nyrstar of a single tonne of zinc works out at $268 (assuming the spot price remains below $2,500), plus the Eu350 processing fee, which brings up Nyrstar's overall cost to around $740 per tonne. On March 31 the LME spot price for zinc was $2,360 per tonne.

Nyrstar quickly followed up the deal by launching a Eu100 million issue of five-year bonds with a coupon of 5.5% on March 23, closing the offering in just two days after it raised Eu225 million. The bookrunners on the bond issue, sold in Belgium, were ING and KBC. Nyrstar concurrently closed a Eu400 million multi-currency structured commodity trade finance facility in March – a four-year loan priced at 190bp over Euribor. The facility was originally proposed at just Eu250 million but proved popular in syndication.

Strengths and weaknesses

Rather than acting as a threat to the commercial banks, deals like the Talvivaara prepay offer those banks an opportunity to develop relationships with both junior miners, who need to be increasingly creative in the ways they raise equity to advance their projects, and traders, which need to secure supplied but are forced to operate in shorter-term markets because they lack the big balance sheet required to take a longer-term approach.

"This is integrated into what is needed for project finance in any event," says Mosely. "Particularly with base metals, it is important to have good offtakers in place. The challenge for us is how to support those offtakers."

On the Rosemont deal, the trade-off for Augusta – apart from giving up the upside potential on its secondary output – is that by stripping out a part of the project's cash flow it is reducing its actual capacity to borrow. So the decision was not about finding a complementary source of funding to increase the project's bankability but rather a straight up cost of funding calculation: Silver Wheaton was able to offer a pre-pay more cheaply than banks are able to finance off a hedge on the secondary stream.

The problem with combining a royalty stream with a project financing is that in practice the deals are extremely complex. "When structuring these deals inevitably the discussion is about how to stream a claim against the asset and be able to frame that in such a way as to make it bankruptcy proof," says one banker who has read the documentation for Rosemont. "Lenders have to acknowledge the stream upfront, then you have to hope to God that someone will write a legal opinion endorsing it. It's not the case in all countries that the laws are clear on this."

But Don Hultman, head of project finance London at Standard Bank, argues that such structures are often seen on oil and gas deals and lenders are comfortable with them. "If the royalty stream can be carved out and separated from the rest of the asset then it's not problematic," he says. "Royalties and taxes are near the top of the cash flow waterfall, so lenders don't see much of that anyway."

Is this a trend?

Signs that the project finance debt market is rebounding are still quite tentative. Bankers report that they are looking at more deals and that conditions have improved, but the proof of the pudding will come when more project finance deals start closing, something bankers appear confident will happen this year. A strong indicator of the turnaround came in March when European Nickel – which opted for a Chinese finance solution for its Caldag project in Turkey when the project finance market collapsed last year – announced it was once more in negotiations with international project finance banks and said it was hoping to get a deal closed in the second quarter of this year (see box 2).

Where precious metals are a by-product of a mine's output there is a strong potential arbitrage role to be played by royalty houses that can cover a large portion of a project's construction costs. Rosemont and Barrick will show how easily these can be integrated with project finance rather than corporate finance debt structures.

Base metal deals where traders are able to pay an upfront for a mine's output, as on Talvivaara, are likely to remain rare. That deal was partly made possible by the strength of Nystar's balance sheet and the strength of Talvivaara's nickel revenue stream.

Banks are working together with junior miners and metal traders on between six to 12 hybrid financing deals. Some of these will not strictly be pre-pays along the lines of Talvivaara but will involve the traders investing in the mine and paying on delivery for the mine's output rather than upfront. A difficult climate for raising capital could see imaginative solutions come to the fore.

Box 1 -------------------------------------------------------------------

Refinancing pipeline

In the first quarter of 2010 several developers with project finance facilities already in place have opted to take them out with a variety of different structures. Talvivaara paid off its entire project debt in January by selling its zinc output upfront to Nyrstar for $335 million, then in March Equinox Resources refinanced Lumwana, a Zambian copper mine originally financed in 2006 using a complicated project finance structure with ECA and multilateral tranches, with straightforward corporate debt.

Miners are eager for upside, but project finance banks continue to insist on sufficient hedging to reduce borrowers' commodity exposure. This, and the overall restrictiveness of project finance structures, explains why many miners that managed to put debt in place during the boom times would like to find alternatives now their mines are producing.

"Any mining project that got project financed between 2005 and 2007 will be looking at exits from project finance," says McCann. "Either they will be able to persuade existing banks to offer more flexible terms because they have a good asset, or they will try and adopt more flexible trade finance offtake or streaming structures, or a bond exit. There's a real myriad of options." According to McCann, during the boom time miners intended to replace their project finance facilities with corporate loans or bonds. Talvivaara has shown what can be done with its pre-pay, and hybrid financings could prove a common option.

The Lumwana project achieved increased operational flexibility through the corporate refinancing route. Originally financed in 2006 with $583.8 million of project debt and an additional $80 million add-on in 2008, Equinox has raised a $400 million corporate facility from Standard Bank, Standard Chartered, BNP Paribas and Industrial and Commercial Bank of China, broken down into a $220 million three-year term loan priced at 400bp and a $180 million five-year revolver with an optional one-year extension priced at 475bp for the first two years, dropping to 400bp thereafter.

But for Kenmare Resources – another sponsor with project financing from the boom times – raising capital to expand its business has been more painful. The sponsor of the Moma titanium mine in Mozambique raised £179.6 million ($272.7 million) through a share offering in March to finance a $200 million expansion work on the mine. The placing, underwritten by JP Morgan and Davy, attracted a mere 73.5% take-up rate. The Moma project was subject to some teething troubles in construction and is yet to turn a profit. The new equity provides £133.1 million for a 50% increase in capacity, the remainder to be used for general capital purposes, including the servicing of existing debt.

Box 2--------------------------------------------------------------------

Caldag retreats from Chinese solution

For developers of base metals mining projects, another option is replacing western banks with Chinese ones.
Chinese banks are able to take a more integrated approach to funding projects. The engineering, procurement and construction contractor, export credit agency and banks will act together to consider factors such as the country's balance of payments and other interests, something that a western commercial bank would scarcely consider. They will generally not ask for hedging to be put in place, and are able to lend at a higher debt-equity ratios.

But the process is not without complications. Deals typically take a long time to bring to close and more than one source has described the whole process as "opaque". The option's availability partially redresses the balance for junior miners, which have often felt squeezed by project finance banks.

For its Caldag project in Turkey, European Nickel needed to raise 80% debt, but Societe Generale, Standard Bank and Standard Chartered – the project's original lenders – were not prepared to lend at such high gearing. This led European Nickel to look to China for the financing, and in February 2009 it appointed China Tianchen Engineering Corporation EPC contractor and initially agreed to an offtake contract for 50% of the mine's output with China's state-owned Jiangxi Rare Earth and Rare Metals Tungsten. This became 100% in the middle of 2009 when BHP Billiton, the original offtaker, released Caldag from its agreement, raising the prospect of a wholly Chinese project financing with $350 million of Sinosure-covered debt with an eight-year term, to be provided by ICBC.

However, negotiations have dragged on, and in March European Nickel extended the deadline for agreeing the Chinese finance to May 14, while in parallel restarting talks with international banks with the expectation of mandating arrangers in the second quarter, after expressions of interest were received in January. Whereas the original international project financing was to be done as a syndicated deal, European Nickel is now looking for a club deal likely to involve five to seven banks.

The timetable is to get the project financing closed by the end of the second quarter, though that looks optimistic, with a third quarter financing looking a likelier option. An international project financing would involve BHP Billiton returning as the offtaker, while theoretically the Chinese project financing also remains a possibility. The two would no longer be combined.

Meanwhile European Nickel has kept the project moving with equity injections. An equity placement in February raised $19.4 million, which was used to pay off a $5 million bridge loan from Endeavour Financial, the financial adviser to Caldag.