02 August 2016

Opportunities for the Bold - Africa mining M&A in 2016 and beyond

This article was written by Paul Schroder (partner) and Ryan Gawrych (managing associate).

After 2015's race to the bottom, the start of 2016 has seen a gradual rallying of the mining industry in Africa. Commodity prices and equities have rebounded, driven by local currency weakness against the US dollar, lower input costs and a focus on deleveraging.

However, the upswing in M&A activity that many predicted for 2016 has yet to materialise. A recent note from Macquarie Research highlights that the sector’s share of global deal-making is currently at 3%, the lowest point in over a decade, with only a handful of deals completed in Sub-Saharan Africa so far this year. With ongoing volatility, a slower rate of global economic growth, oversupply in key commodities and poor investor sentiment, further pain is expected in 2016 before the market sees any significant resurgence in deal-making activity.

While the immediate outlook is subdued, we believe that there are a number of bright spots and once in a generation opportunities for those with an eye to the medium and long term.

The rise of gold

Gold has been the standout performer so far in 2016 amid a wave of M&A activity in West Africa. Recent deals have included Perseus Mining’s expansion into Côte d’Ivoire and Sierra Leone by taking over LSE-listed Amara Mining, Teranga Gold’s acquisition of Gryphon Minerals* (an ASX-listed company with fully permitted operations in Burkina Faso) and Endeavour Mining’s buy-out of another West African gold miner, TrueGold Ltd, for US$180m.

The majority of acquirers are wellcapitalised North American and Australian gold producers looking to consolidate and geographically diversify. As the gold industry was the first in the sector to restructure, many producers are ahead of the pack and in a position to take advantage of healthy balance sheets and strong cash flow amid strengthening gold prices.

Gold is currently sitting at around US$1,350/ oz after a prolonged run fuelled by uncertainty, low interest rates and inflamed by Brexit. Looking forward, with the US Federal Reserve likely to hold on rates until the end of the year, ongoing global political volatility and declining production in the near term, the price of gold is set to rise further. This is good news for producers given the strength of the US dollar relative to local currencies. As project costs are usually paid out in local currencies, while gold is sold for US dollars, the increase in profits will create favourable conditions for the acquisitively-minded.

We therefore expect that the remainder of the year will see further consolidation in gold with a focus on pre-production opportunities where many African juniors remain undervalued or in distress. We would also expect to see the South African-based producers such as Sibanye Gold, Harmony Gold and Gold Fields to take advantage of market conditions and increase their portfolios in West Africa.

Gearing up for divestments?

Despite the uptick in commodity prices since the beginning of the year, miners remain distressed. As in the rest of the world, miners in Africa are shedding non-core assets in order to strengthen balance sheets and maintain overall liquidity. This includes cash-strapped majors such as Anglo American, Glencore and Freeport-McMoRan who have all kicked off disposal processes for a mixture of coal, iron ore and copper assets throughout South Africa, Botswana and the DRC. But, with market headwinds and a value expectation gap between buyers and sellers, few deals have been closed to date.

While we anticipate that distressed assets will continue to come to market throughout 2016 and into 2017, we do not expect this to be the catalyst for a large increase in M&A activity. Miners have become more risk-averse since the peak of the last cycle, capital remains scarce, execution risks are high and proportionately few upper quartile assets are likely to appear on the blocks. In this environment we see the next 6-12 months as more a period of careful and disciplined acquisitions rather than opportunistic bargain hunting.

For those miners in a position to pursue distressed deals, there are once in a generation opportunities and the focus will be on those that offer growth and genuine long-term value, whether by realising improved operating synergies, commodity and geographical diversification or (as is likely among the midcaps) consolidation which paves the way to becoming leading producers when prices rebound. Justifying such value propositions will be particularly important to publicly-listed entities as shareholders remain wary of any new buying spree.

We expect that with a greater focus on quality and aversion to risk, distressed assets in stable and well-understood mining jurisdictions, like Ghana, Botswana and Namibia, will be particularly attractive. Nevertheless, copper, iron ore, platinum and coal assets in South Africa and the DRC (especially those being sold by the majors) will also attract attention purely because of their high quality, notwithstanding political instability, corruption issues and regulatory uncertainty within those jurisdictions.

Chinese and Private Equity eyeing opportunities

With much of the industry capital constrained, cashed-up Chinese companies and private equity players have the funds to pursue countercyclical opportunities in Africa. We expect to see further activity from both these corners of the market as the year progresses.

Chinese buyers are looking to take advantage of challenging conditions to secure strategic assets that wouldn’t be sold but for debt. The ‘new normal’ and slowdown in demand for industrial metals also means that Chinese miners are pursuing commodity diversification strategies to ensure they are in a stronger portfolio position when heading into the next cycle.

For example, China Molybdenum’s* recent US$2.65 billion acquisition of Freeport’s majority stake in the Tenke Fungurume mine in the DRC provided China Molybdenum with not only another prime copper asset, but also significant exposure to cobalt – one of the specialty metals used in rechargeable batteries and medical equipment.

Based on what we have seen in recent months, astute Chinese miners, like China Molybdenum, are willing to pay full value for strategic assets.

Despite sitting on an estimated US$7-10 billion in raised funds earmarked for mining, investment by the private equity firms has been elusive in 2016. Activity in Africa has been particularly thin, with only very small deployments such as Tembo Capital’s US$4.75 million placement in Strandline Resources’ Tanzanian mineral sands project. Nevertheless, there has been substantial interest and tyre-kicking, suggesting that it may only be a matter of time before more of the private equity players make their move.

While private equity has a good hand at the moment, Bert Koth, Managing Director of Denham Capital’s mining division, has noted that private equity funds cannot compete for strategic assets with Chinese buyers that have a much lower cost of capital.

With this in mind, we see real opportunities for private equity in the small-mid caps, especially given the potentially greater yields that can be generated from backing development stage projects and the increasingly distressed disposition of the junior market. This also aligns well with the landscape in Africa, which is dominated by small developers, and we expect to see an increase in the number of deals involving funds and low-cost startups that are run by teams with genuine track records, in stable jurisdictions and in commodities that have a strong future (e.g. copper, zinc, nickel, gold, platinum, tungsten and rare earth elements). We are also seeing increased interest by private equity firms in South African uranium and coal opportunities.

Pursuing non-operating interests

Takeovers may have dominated the deal activity in Africa’s mining industry in 2016, but the acquisition of smaller non-operating interests is becoming increasingly attractive as a low-risk strategy to take advantage of a bottoming market.

Acquiring non-operating interests provides a much needed life-line for project proponents but also allows investors to share risk with the majority owner while facilitating cost effective diversification, as multiple interests can be purchased without the need to pay control premiums. It also allows investors to strengthen their reputation with operators and stakeholders in key markets, secure off-take and add value through the application of technology, geological insight or commercial know-how.

In the context of Africa, we see this strategy playing to the strengths of the acquisitive Japanese trading houses such as Sumitomo, Mitsui and Itochu (Mitsubishi being a notable exception given recent announcements that it does not intend to increase its net exposure to resources for at least the next three years).

These trading houses are comfortable with non-operating interests, have a need to secure long-term off-take and have built up a portfolio of financial, infrastructure, power and transport assets in Africa (particularly East Africa), which can be brought to bear in supporting project development.

They are also sitting on large cash reserves (Citigroup estimates that corporate Japan has some US$3 trillion in holdings) and have been actively encouraged by the Japanese Ministry of Economy, Trade and Industry to pursue investments in Africa.

As such, we expect that the latter half of the year will see the more assertive of these trading houses begin to take up minority positions with offtake agreements in base and industrial metals, including by way of opportunistic approaches. However, only prime assets with associated infrastructure opportunities are likely to capture their attention.

The tech effect

In Africa, the big-hitting commodities have traditionally been diamonds, iron ore, gold and copper. But with the global energy landscape rapidly changing and disruptive technologies on the rise in 2016, many investors are turning their attention to opportunities in specialist technology metals during the current downturn.

The posterchild for this trend has been lithium. An essential component in lithium-ion batteries used by the EV manufacturing and telecommunications sector, lithium has tripled in price since the beginning of 2015 on the back of forecast shortages in both carbonate and hydroxide. At the same time, the number of acquisitions involving lithium has skyrocketed as companies seek exposure to the metal.

While Africa has lithium deposits in Zimbabwe, Niger, Namibia, Senegal and Cote d’Ivore, it has seen very little deal activity in the sector. We don’t expect this to change. As is the case whenever companies scramble for exposure to a particular metal due to investor appetite, speculation often overshoots demand and there are increasingly loud voices pointing to the impending burst of the lithium bubble.

Interestingly, natural spherical graphite, which is used in greater quantities in high-end lithium-ion batteries than lithium, has received little attention. Almost 100% of this graphite is produced in China and with demand outpacing supply there will be opportunities in jurisdictions such as Tanzania and Mozambique for those companies looking to diversify sources of supply.

Beyond lithium and graphite, specialist metals such as cobalt, cadmium, tungsten and zirconium are expected to see increased demand over the long-term as they are critical to consumer electronics and clean energy technologies. As these metals are produced as by-products of base metals that are plentiful in Africa, we see this as another potential value driver for companies looking at acquiring distressed assets.

Outlook to 2017

Overall, we expect that tough conditions and a cautious approach in securing the right assets, at the right price, will ensure deal activity in Africa remains lacklustre into 2017.

However, long term fundamentals remain strong and it may only be a matter of time before M&A normalises in African mining. In the meantime, the boldest and most well positioned companies will take advantage of lower prices and a glut of assets to ready themselves for the next phase of the cycle.

More articles from Made in Africa Issue 15:

Permanent Capital Vehicles - Are they worth it?
UNPRI publishes a standardised DDQ on responsible investing
Made in China? Financing Nigeria's infrastructure
Asian Influence - Singapore’s increasing role in Africa
Financial regulation in South Africa - New developments

A Guide to Doing Business in China

We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

Doing Business in China

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