Merrill Lynch has put its own money to work alongside a couple of hedge funds in yet another highly structured equity deal, which will provide financing for an Indonesian coal mine at a time when global demand for this commodity continues to increase.
The $135 million transaction stands out not only because it was completed last week in the midst of one of the most volatile periods in Asian equity markets in recent years, but because it is a greenfield project that currently contains nothing more than the coal in the ground, a reserve report and a management team.
In an unusual move for an investment bank – especially in a deal it is structuring itself - Merrill Lynch has also entered into an exclusive multi-year offtake agreement to buy all the coal produced by the new mine in the initial years. This level of involvement is noticeable because it significantly increases Merrill’s exposure to the project, but makes sense when one takes into account that the US investment bank also owns commodity and energy trading firm Entergy-Koch, which is keen to get its hands on more physical coal.
For the other investors participating in the deal, this type of guarantee will also provide additional comfort about the credit worthiness of the company.
The open pit mine, which is owned by PT Ilthabi Bara Utama (IBU) and located in East Kalimantan, won’t be ready to begin operations for almost another year – the expected start is June or July 2008 – but a very low strip ratio (which measures how measure of how much waste material has to be mined for every volume of mined ore) should allow for a quick ramp-up in production that will make it “quite a large mine” within just four or five years, according to IBU’s two backers.
For the same reasons, the production costs will also be quite low and the mine will be profitable in its first year of production with expected earnings before interest, tax, depreciation and amortisation of $40 million to $50 million in the first 12 months, they say.
“We are expecting to be running at a rate of 5 million tonnes per annum before the end of our first year in operation, which is pretty fast for a mine, and we will probably ramp it up to 10 million tonnes per annum within about two years of the start of production,” says private equity specialist Patrick Alexander, who is one of the two sponsors. “Indeed, with further investments, we will probably get to 20 million tonnes per annum within five years of the start of mining.”
That will compare with an annual production of 30 million to 40 million tonnes at the biggest Indonesian mines. Still, a production rate of 20 million tonnes could produce an Ebitda of $200 million per year, based on the company’s current forecast margins, he adds.
The IBU mine’s proven probable reserves of 270 million tonnes, or just under 10% of the overall coal resources of approximately 3.3 billion tonnes, already makes it one of the top five coal mines in Indonesia. That ratio is expected to increase to about 20% by the time the company starts mining as additional drilling before then is expected to produce a mineable reserves figure of 600 million to 700 million tonnes, which according to a Alexander is “more than enough for many years of mining.”
The deal, which was put together in about four months after the completion of the reserve report and the offtake agreement in March, consists of equity-linked notes with a 4 year and nine month maturity but with a detachable convertible equity element that doesn’t expire until 2037. The equity units entitle the holders to part of a royalty stream that will be paid out of the Ebitda and can be exchanged for equity in the unlisted company once the notes expire. They will be automatically converted in case of an initial public offering.
IBU, which means mother in Bahasa, won’t be coming to market for the next few years, however, and when it does it won’t be to create an exit opportunity but rather to raise new capital for continued expansion, the sponsors say.
“We probably need more money to ramp up production to get above say 10 million tonnes (per year) as we need to invest in more equipment and more sophisticated transportation such as larger conveyor belts," says Ilham Habibie, the founder of an Indonesian investment company and the second sponsor of IBU. "We think when we are moving strongly towards the 20 million tonne threshold that will probably be the right time to start thinking about going public. From today that will be perhaps in another three to four years.”
According to sources familiar with the transaction, the three note holders will own a bit less than 10% of the company if the notes are fully converted. Meanwhile, the notes will pay an annual coupon of 10% and the investors can expect an internal rate of return of 25%-30% as the notes will be redeemed at a premium.
As a security for the investors the deal is pre-funded for two years, meaning part of the $135 million will be put aside to pay the annual coupons to cover the period before the mine becomes fully operational. In addition, IBU will get its hands on the money on a staggered basis with each draw-down having to be preceded by the passing of pre-defined milestones. The first draw-down, which will account for about one third or so of the total capital, will be made next week and among other things will be used towards the construction of a road from the mine to the river, a river port, the acquisition of barges and other transport vehicles, as well as the ground work needed before the mine can bee opened.
The actual mining operations will be outsourced to a separate company, according to a model that is commonly used in Indonesia. IBU has shortlisted a couple of candidates, but the final decision has yet to be made.
According to Alexander and Habibie, the key advantage of this type of privately arranged funding is that it gives them the ability to build the mine with relatively minor equity dilution, albeit at a high cost to begin with.
“And because we believe this is a mine that can be ramped up quickly because of the relative simplicity of the mine and the shallowness of the coal, it will allow us build up the enterprise value by beginning production as fast as possible and then refinancing the notes. At the same time we have given an equity kicker to the investors in those notes,” Alexander says.
Project financing, which alongside equity is the other obvious solution for large-scale greenfield projects, is typically not available for start-up companies and does in any case also take much longer to put in place.
For Merrill, this deal can be expected to bring profits on several fronts, given that it is involved both as in investor and as the buyer of the coal – although it will have to share some of the profits from the eventual sale of the coal with IBU depending on the price achieved – and on top of that it will collect an undisclosed, but likely quite substantial, fee for structuring the deal in the first place.
Sources didn’t have any information on how much Merrill or the other two investors put into the deal, except that it wasn’t an even split. However, in previous deals of this type, where a portion of the investment has been syndicated out to other parties, Merrill has typically kept between 15% and 25%.
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