Funding: Institutional Investing and Private Equity, How Institutional Investing Works

This episode will give an overview of how long only funds and private equity funds work. Hedge funds are not included in the discussion beyond saying that these are funds where they can go both long and buy the underlying equity or can go short and sell short the underlying equity. And typically hedge funds need deep liquidity to be able to borrow stock in order to sell short which rules out most of the junior mining sector, which of course sits at the more illiquid end of the stock spectrum or the trading spectrum. Therefore, I'm not going to spend any more time on hedge funds as they are not one of the main sources of funding for exploration and development company. It is important, however, for investors to understand how long-only funds and how private equity funds work, because these are two key sources of funding for exploration and development resource companies.

And from what I can see from the chat rooms and the bulletin boards, I think it'd be helpful to shed some light on some of the inner workings of these funds and how they reach investment decisions and the differences.

First of all, for simplicity's sake, I'm going to call long-term funds institutions and private equity funds private equity or PE. To make a gross generalisation, one could say that the main difference between institutions and private equity is that institutions are typically structured to hold publicly quoted equities, publicly traded stocks, and will only rarely invest in private companies.

Private equity, there's a clue in the name, is typically structured to invest in private companies. Another difference, again with a caveat of making another generalization, is that institutions prefer low profile minority positions that avoid having to be declared or even worse a position that crosses a change of control threshold, which is 20% in Canada or Australia or 30% in the UK. Those change of control thresholds means that the fund therefore has to make an offer to all other shareholders to buy their position. So institutions prize liquidity and the ability to trade in and out freely and independence very highly. They don't want to be tied down by regulation. Institutions are typically owners but without strings attached. This means that as a general rule, institutions only get involved with strategic decisions at the board level of a company when things are going extremely wrong and they feel the need to step in. Or extremely right and senior management on the board is just kind of asking an opinion which of two quite good outcomes the fund manager would prefer. Kind of as a sounding-board exercise.

Private equity on the other hand, generally takes a much more integrated approach to any investment. Strings are almost always attached and positions are almost always large enough and strategic enough for the PE group to have a proper say in company strategy.

Quite often, a PE investment literally comes with a seat at the table with one or more board positions. In summary, institutions like minority positions in public companies and private equity likes strategic stakes in private companies. Yet, despite this fundamentally different

starting point, the Great Bear Market from 2011 to 2017 mixed everything up and things are still mixed up and a little bit confused.

Let me explain. It may be stating the obvious but Public companies trade on the stock exchange and the value of the shares varies according to the level at which people are prepared to buy or sell shares at. And in a horrific bear market like the one we experienced, no one really wants to buy the stock and so valuations can collapse. And from 2011, my goodness, collapse they did. Most junior resource companies dating from pre-2011 are part of the 99% club, where share prices fell by around 99% in the downturn. Pretty ugly and they produced share price charts that you wouldn't want to ski down.

Private companies, however, were spared the excesses of the downturn as long as they didn't need to raise capital. And the reason is that private companies are typically valued on the basis of the number of shares multiplied by the price of the last issue of new shares. Which means that if a company raised money in the good times or better times, no matter how bad the new bad times become, the private company can point to the price of its albeit historic share issuance. Multiply it by the number of shares outstanding and say, look, our company is worth X. And you've got to add into that, that fund managers hate having the book value of their private holdings marked down in a bear market. So, for example, if a fund has got 10% in private companies, when fund performance is under pressure because of a bear market, when the 90%, which is in the publicly traded portion of their portfolio is under pressure, it's nice for the fund manager to have an overall performance buoyed by their privates in the portfolio, even if it is an artificial measure.

So nobody wants to see those private companies downgraded or have their book value reduced. It is in no one's interest. But coming back to the great mixing during the bear market, the key factor was that private equity became a major funding source for publicly traded stocks. While generalist institutions headed for the resources sector exit, private equity, which struggled to deploy capital during the boom proceeding the bust, had cash on hand to invest. PE funds hadn't deployed their capital. And because private companies technically held their value, in real money terms, there were many much cheaper entry points into good quality assets in the public markets. And so it was that from 2011 onwards, the PE groups became increasingly important funders of last resort for the public sector, to the point now where the words private equity have lost their resonance with regard to the word private and instead simply represent the different approach it makes its investment decisions to an institution.

Let's have a look at some of these factors which affect the decision-making process, both for Institutions and for PE, starting with Institutions.

Okay, remember that the vast majority of Institutions, they measure themselves against their peers and against the market. For Institutions, it's a relative game, not an absolute performance game.

This means that generalist investors are not intrinsically wedded to the resources sector but they will afford it attention if it's clear to them that it will help them outperform their peers. Indeed, as one fund manager famously told me years ago, “the rest of my portfolio trades in

line with the market but resources gives me the sex and violence I need”. So resources can spice up your portfolio. Overweight resources in a bull market? In a prolonged bear market, the generalist funds will want to be underweight resources, and they will only rebalance their positions when valuations have stabilized or are at cyclical lows. And this cyclical nature of the sector, plus the need to outperform peers, means that truly specialist resource funds are few and far between. And leading on from that, one has to take into account the fact that a general investor won't necessarily have the in-depth technical background to really understand the bottom-up technical aspects of the business that is so important for assessing the potential of single-asset companies or pre-production companies. The fund managers have a wide variety of sectors to deal with, so it's much easier for them to play the cycle than to get involved in the weeds of high-risk small-cap stock picking. And for this reason, generalists are typically better suited to playing the larger end of the spectrum - production companies - not the pre-production junior end of the sector.

Another key factor is liquidity. Many institutions are enormous, many billions of dollars, where liquidity and the ability to trade positions without crashing or spiking the market is absolutely vital. And remember that any investment has to be relevant to the size of the fund and you may ask yourself what is deemed relevant. In my experience, having been in a fund, 50 basis points is a good guideline for being relevant. So 0.5% of the funds under management allocated to resources or in a fund. Therefore with a $2 billion fund, for example, 50 basis points is 0.5% or $10 million. Therefore anything smaller than that is your minimum stake in the company is irrelevant and a waste of time. So in reality, fund managers want a few high conviction positions, one to 2% positions that can grow into three or possibly more percent positions.

And using the example above a 2% position in a $2 billion fund means a $40 million starter investment, potentially growing to a $100 million or $200 million position in a single stock, which this would be a reportable stake for most junior companies. But it's not such a critically important slug of equity for a mid-tier producing company or larger. And remember that I said that institutions generally don't like to have a reportable stake or cross any kind of control thresholds.

All of this means that many of the bigger institutions don't want to play in the smaller space as it's too difficult to build or sell a position or to be a below-the-radar investor. And of course, if you think about new issues when it comes to raising capital, a $10 million or $20 million investment, let alone a $40 million ticket, would be a huge chunk of most junior mining financings. And funds rarely want to do the whole financing. Therefore, when you factor in the specialization required to play in the pre-production space and the general liquidity of the junior end of the market, it is not surprising that few of the big institutions invest in the smaller end of the sector.

If you speak to funds such as Capital or BlackRock, they term anything with a market capitalisation of $250-500 million as microcap. And yet a large chunk of the retail investors' time is spent looking at the smaller space, with market caps up to $500 million, and often a lot lower than that. I repeat, there are very few specialist institutions that can play in the junior sector, and those that are active in the space are crucially important.

So let's have a quick look now at how they work and how do they choose their investments.

Well, typically funds have an internal hierarchy of decision-making, an org chart process that plays its part before any new position is included in the fund. Usually the bigger the fund, the more formal the process will be. Now many funds will have an internal investment committee with a chief investment officer, CIO, and a portfolio manager, and analysts, and junior analysts. And it can take years to get up the career ladder to become a portfolio manager, and very few people make it to be a CIO.

Of course, it depends what kind of fund you are, but exploration will often be referred to a junior analyst who then has to bring it to the attention of a broader committee, and in particular get the backing of the CIO. It has to be such a high conviction thesis to warrant taking it up to that level. And I've seen many times where companies are talking to a big name fund, they get good traction through lots of meetings, but the investment decision never makes it through their internal discussion on the allocation of assets.

And the junior analysts will then learn that actually it's a waste of time looking at these smaller projects or the smaller companies. So even though smaller funds have a less structured hierarchy, they generally also have to convince an internal investment committee that the investment in a resource's stock is a good idea. And often the smaller funds have to sell their own portfolio, what they're invested in, to their own investing partners, the groups that are investing in the smaller fund.

In a way, a smaller fund is in a similar position to an exploration company in that they're always trying to look to get more people to invest in them, to grow the AUM, to grow the assets under management. They're constantly trying to raise performance, trying to raise more money to make it bigger and to make it more relevant. Because the way that the fund managers make more money is by managing more assets. The greater the assets under management (the larger the AUM), the more money you make both in terms of annual fees and on potential performance fees.

Incidentally, a rule of thumb for fund managers is to ask themselves whether they would be comfortable having the CEO or the C-suite of the exploration company in question in the same room with the investing partner of the fund. So would the pension fund or whoever allocates capital to the fund manager, what would the reaction of those people be if they met the management team of the junior resources company in question? If the thought makes you squirm as a fund manager, more than likely that you're not going to want to invest in that particular junior company.

So a little note to the CEOs out there, if you're too rough and ready, if you're too sharp or too glib, institutions will likely back away. Fund managers have seen it all before, they can be very jaded and presentation does matter. So beards and haircuts and the rugged kind of stuff. But anyway, I digress. When it comes to getting that crucial decision to invest from a fund, timelines can vary. I have seen decisions being made over a single phone call, which is very rare. Normally they've been warmed up for a long period of time to make that decision. I've also seen the other end of the spectrum where decisions come at the result of months, possibly years of meetings. And typically funds are risk averse. What they don't want to do,

what they hate doing, is losing money. So it's more likely to take longer than it is to take less time. Some funds may want to see a long track record of delivery emerge through quarter by quarter performance. And it's a huge commitment to take on a new position. Trust is absolutely vital.

However, once the company has earned that trust, that institution is normally incredibly supportive. As a minimum, you'd expect them to maintain their interest in the stock as the company develops, unless the progress is either very good, in which case they'll want to increase their position, or if the progress is poor, the fund will probably want to just dilute passively by not participating in the next funding round. And remember that through all of this, an institution's goal is to crystallize gains. Therefore, if you do have strong performance, don't be offended or alarmed as a company to see the fund trading around that position. They will top slice.

Although I should say that the secret to a lot of success is backing your winners. So when a fund manager knows that they're onto a company that's really got a three or four year growth path ahead of them, they will probably increase their weighting until they feel as if the valuations are stretched and then they'll start top slicing. So I've also seen fund managers rebuilding their position having top sliced as long as their fundamentals remain positive. So that's - I hope - an insight into how funds work.

Moving on to private equity. As I said, private equity in the resources sector really came to the fore in the last downturn. Because when the generalist money was not available, when the specialist and institution money started slipping away from the section in 2011, private equity stood up and private equity companies or groups began to realise that their entry level into public companies was much lower than into private companies. As I've already said, the private companies were judging themselves on the basis of their own NPVs.

Publicly traded stocks due to the flood of “capital out”, has seen a massive loss of value. Companies couldn't get funded, exploration companies couldn't get funded, therefore they had assets which were trading at a fraction of their, let's call it “real value”. And it was at that point that private equity really started to participate into the publicly traded stocks. Having said that, private equity is a completely different beast to your typical equity institution.

These guys do exhaustive due diligence and they allocate a massive commitment of time to invest in the project. PE teams typically have vast technical experience. They're bristling with engineers and professional geologists and metallurgists. The technical team will usually want access to all of the data available on the project to date and then they will run their own resource model and their own technical and financial assessments. The work they do is almost as rigorous as the kind of work that companies do in mergers and acquisitions. It's also worth remembering that private equity, fund themselves on fund cycles. And so fund one will be, say, I don't know, $200 million or a billion dollars, and they will fill that up with five to 10 positions. And then that fund needs to demonstrate that they've got an exit strategy in order to start marketing their second fund. They don't have to exit all 10 positions, all five positions, but they need to demonstrate their ability to make significant returns on their capital. PE funds are looking for really significant returns. They're not in this to get 20 or 30%. It's too much work, it's too difficult, it takes up too much of their time.

They are looking for two or three or more, preferably five times return on their money. Private equity investments therefore need to be relevant to their own fund and they're not too fussed about what size percentage of any company they become. They don't really care about control thresholds, they don't care about declarable positions. In fact, unit size

for private equity when operating at the junior end of the spectrum is typically much larger than an institution would be happy running with due to those liquidity and reporting constraints. And whereas a fund may have several smaller positions, a PE group will often take fewer positions with a more grueling investment into diligence process. And remember that private equity can become a dominant position in a register which can cause imbalances, especially in downturns or bad times. In scenarios where the prices go down or management makes mistakes, the private equity team can turn from support to being the rod to the back for your management.

And retail shareholders can end up on the wrong side of a dilution kind of situation there. If no one else is going to provide the crucial build capital, then the PE fund can start to dictate terms and perhaps delist the company or tinker with the capital structure. Debt with stringent covenants is a classic.

So as an investor, you have to look closely at the dynamic between the private equity company and the management team. What are those signals there?

A quick sign that things are not going well are subsequent fundings at lower prices where the PE groups are taking progressively more dominant positions. That's a bad sign and it means things are going seriously wrong at an operational level. The private equity group doesn't want to lose its money so it's stepping in to prevent a complete snafu. And you'll see that with more board positions for example. They will support the company because it knows that no one else will. They will pick up a controlling position and at that point it can change the management and then it can restructure the asset, put itself much higher up in the capital structure and guaranteeing that they, the PE group, gets its money out. They're not in this for a charity. They're in this to make money. And at that point, an average, your common-law Joe retail investor, your average shareholder, is going be at the wrong end of the deal at that point.

In conclusion, private equity within smaller companies is not to be embraced blindly. It's not just a good thing that the project is getting built. It's not necessarily problematic and PE can be fantastic, but generally you want to see private equity either very early on, so they back a management team and an asset very early on, and they start diluting in the general progress of a company, or they come in late when a 20 to $30 million investment is only worth, say, 10% of the capital.

When they come in the middle, and they take a dominant position on the register, and then perhaps something goes wrong in the development phase, it can be much more challenging for your average equity investor.

I hope that's a useful guide to Institutions and private equity.

Thank you very much.

‍