The Covid-19 pandemic has had a devastating effect on economies and markets around the world. Market participants have sought refuge in the USD, to the detriment of most other asset classes. The resultant selloff within the mining sector, with its high volatility and low liquidity, has spared no one.
Whilst in our lifetimes many of us have seen deep retracements in markets partnered with elevated price volatility, none of us have seen anything like the market reaction to the Covid-19 pandemic. In recent memory, these extended selloffs have not only provided good buying opportunities for both the underlying commodity and the mining stocks but have created market dislocations that offer generational opportunities for high returns within a de-risked investment environment.
These generational opportunities have arisen because the mining sector differs significantly from other sectors for a variety of reasons and risks. One peculiarity of the sector is that mining companies, as price-takers, may today, with unchanged operational performance and through no action of their own, generate (say) 60% of the revenue they might have been generating 30 days ago. Consequently, as mining sector investors, we invest in companies that all have a constantly changing revenue line over which they have limited control, which in turn feeds directly through to the bottom line.
This key characteristic of the sector results in the performance of mining stocks being leveraged to the performance of the underlying commodity being produced. In times of great stress in the market, as we are witnessing today, we see this leverage effect overextend. The result is a great market dislocation between the prevailing commodity price and the publicly traded stock price.
Our private equity investment thesis and structuring approach at Acrux Resources is driven by a keen understanding of the implications of this market dislocation and thus the investment opportunities that arise from it. To benefit from the dislocation, we reduce commodity price risk by hedging, whilst simultaneously buying the producing company. This has the effect of capturing the value in the dislocation and, at the same time, de-risking the deployment of capital.
With forecast cash flow generation more certain as a result of the hedge program, suitable leverage can be raised against the transaction to further maximise equity returns. Due to the dislocation, the predictable cashflows are sufficient to return all capital to the debt and equity capital providers within the appropriate commodity hedge period, thereby skewing the risk/return profiles for those capital providers. Once done, our equity partners are then left with an effective “free” call option on an unhedged mining business.
With the investment financially de-risked, the risk that capital providers are really exposed to is the operational performance of the underlying business. Acrux has always addressed this risk by implementing a rigorous bottom-up approach to assess the technical and operational viability of each investment opportunity. This is done to ensure that a deep understanding of the operational risks and opportunities of each investment is developed. This process is driven by our experienced technical team, who act as first-line gatekeepers to any investments we undertake.
We at Acrux are currently actively monitoring a selection of mining companies and assets that are technically sound and have competent operational management teams, to identify investment opportunities that will offer our partners generational opportunities for high returns within a de-risked investment environment. As we saw in previous market routs, the markets will overextend, and the dislocation will materialise. We will be ready to provide our partners with these investment opportunities.