How Certain Components of a Resource Loan Can Address Both Inflation and Default

By Jon Sebastian

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Two months ago, we wrote in Sprott’s Thoughts about resource-based loans.  The construction of these loans is comprised of three primary components:

  1. A coupon
  2. An equity ‘kiss’
  3. Collateral

These components were briefly explained in the Sprott’s Thoughts article on March 4th, which was titled,“How Sprott and Rick Rule Carefully Construct Mining Loans for Both Inflation Protection and Annual Yield.”  You can read the article by clicking on the link, and we thought it would be useful to more fully define the three primary components of these resource loans:

1.     Coupon

The coupon is the interest payment from the lender to borrower for the use of capital until the principal has been repaid. The coupon rate, or interest rate, is the key form of remuneration for the use of the funds, and as Rick explained in the article linked above, lenders in the mining space are currently able to charge relatively high interest rates partly due to a lack of competition in the space.

2.     Equity ‘kiss’

The equity ‘kiss’ gives the lender upside and inflation protection through exposure to the equity of the borrower.  This upside equity exposure likely becomes particularly important during a time of high inflation, when the inflation rate might exceed the coupon rate of the loan.  There are usually two manifestations of this equity exposure:

a.     Convertibility – If the stock price of the borrower increases to a certain level, the len der can convert either a portion of or the entire loan into equity of the borrower, usually at a fixed price and by a predetermined rate of conversion.

b.     Warrant- Instead of convertibility, Rick and the Sprott team will often negotiate for a warrant on top of the loan.  A warrant is a derivative that confers the right, but not the obligation, to buy equity at the exercise price before expiration.  If the borrower’s stock price rises above the exercise price, as would likely happen during significant inflation, the warrants give the lender the right to buy the stock at that lower exercise price, locking in profits from the rise in the stock price of the borrower.

3.     Collateral

In high risk loans to natural resource companies, lenders must seriously consider who would be paid in the case of default and liquidation of the borrower.  Rick and the Sprott team negotiate a claim to the borrower’s assets (the collateral) into the terms of the loans.  The value of this claim to the borrower’s assets must be correctly evaluated by the lender in order for the collateral to truly back up the value of the loan.  A lender to mining companies must have the ability to value the mining assets, and to interpret that value under a range of possible commodity price environments.

Some of the high risk in giving loans to single mine developers can be mitigated by the ability to evaluate and negotiate a robust coupon rate, value-adding equity component, and proper collateral.

As Rick said in a recent interview,

“Savers today are heavily penalized for leaving cash in the bank because of extremely low interest rates, and must seek higher-risk ventures for an adequate return.  There is an opportunity right now to exploit the shortage of capital in the resource markets and address the large gap between project finance returns – which are historically high – and returns from savings accounts, which are close to negligible.”

For certain investors, lending to natural resource companies may prove advantageous in the current climate.

If you have any questions about these loan components or resource lending investments, please contact your Sprott Global broker or the author of this article, Jon Sebastian, at 760-444-5271 or through email at [email protected].

To claim your discount today, please click here. (Mention Proven & Probable)

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