CPP Investment Board lenders learn painful lesson as Rubicon Minerals "melts down"

News report: Rubicon Minerals Corp shares plunge as miner slashes its gold resources by 88%

One of the rules one must have is to never be critical of another industry player when one of their deals goes sideways. You can’t be sure what you’d have done differently had you been in the same situation. You don’t know what promises were made, or what information the other lender was given (or was hidden from sight) as part of their due diligence process. As such, it never seems appropriate to do a “tsk, tsk” at someone’s misfortune; a bad deal could just as easily as happened to you. This is particularly true in tough workouts when preservation of your capital becomes job number one.

That said, given all of the red flags that should have been obvious to our pension staff, not to mention the fact that my own retirement funds are involved, the potential US$50 million financial disaster that has recently befallen CPP Investment Board Credit Investments Inc. can`t go without mention.

It took less than six months for our Rubicon Minerals (RMX:TSX) loan to go in the dumper.
That a new loan went sour so quickly, and so early in the CPPIB private debt group’s mandate – with such a small sample size of closed transactions under the new team’s belts – will shock many in the lending business. You have to wonder what CPPIB CEO Mark Wiseman’s reaction would be if an external debt fund managing, say, $1 billion of CPP capital had this kind of screw-up; and if he brings that same perspective to bear when his own team faces a similar challenge. I definitely know how our firm’s institutional investors would react if a US$50 million deal hit the wall within 150 days of closing.

It must have come as a surprise for the CPPIB Board of Directors to open the newspaper and read that once Rubicon’s interim management had a careful look under the covers, they discovered that there wasn’t much gold to speak of at their proposed gold mine.

At least not at attractive concentrations.

Or that the entire company was still pre-revenue, which is as risky a situation as a lender can ever find themselves in. Unless the business plan is fully funded, with contingencies, and there’s hard collateral to boot, a pre-revenue situation is merely equity risk at debt pricing.

How did this happen, CPPIB Directors probably asked themselves? What due diligence did we do? And why is one of the first of CPPIB’s private debt transactions being advanced to a pre-revenue mining play in any event? Particularly one that hadn’t validated its reserves in the manner accepted by stock market regulators?

Even worse, CPPIB Directors must be wondering, where are our internal controls? CPPIB’s been in business for 15 years, and one would hope there is a policy for everything by now. And if not, who is to blame for that?

I first caught wind of trouble at Rubicon Minerals (RMX:TSX) on November 4th, when sell-side Equity Research Analysts shared the news that Rubicon’s new Interim CEO had decided to “temporarily” suspend underground activities at the would-be gold mine. According to company disclosures, operations had consumed $33 million in the third quarter and cash was down to C$52 million as of September. The CPPIB lending team would have surely noticed that working capital was just over $30 million, which meant the company’s liquidity would have been exhausted by December in the absence of new capital or huge spending cuts. Or an new advance from our CPP as senior lender.

Analysts cut their share price targets by more than 50% on the news, although the stock was trading at $0.26 by this point — substantially below the $1.715 strike price on the warrants that were issued to CPPIB less than 6 months earlier as a sweetener on its loan. (In fact, CPPIB’s debt team was granted warrants to buy 2.5% of Rubicon’s equity as partial consideration for making their loan in the first place. On a senior secured facility. That warrants haven’t been available on most traditional North American junior mezzanine loans since 2009 is another example of just how risky banks and other private lenders believed this particular loan opportunity to be.)

In a line that caught my eye, one Bay Street Equity Analyst reported that “the geometry of the host rock is more complex than previously interpreted.” This finding, if you can call it that, forced Rubicon management to work with independent consultants to “upgrade the geological model and deliver a revised mineral resource estimate leading to a new plan by Q2/2016.”

With $30 million in working capital and a mill still to complete, there probably wasn’t enough runway even then. One had to assume that another financing was surely required before gold started to pour. Not a great situation for any resource lender, One industry source deadpanned: “it’s not really what you would do.”

I did some more digging, and, according to my industry sources, the initial geological work and valuation of the Phoenix gold project “was literally done on the back of an envelope.” How, then, did Rubicon get the attention of seven different research analysts (BMO, Mackie Research, National Bank Financial, PI Financial, Scotiabank, TD Securities and CanaccordGenuity), six of whom are so proudly displayed on the company’s website?

One has to wonder what role mining lawyers and Promoters played in all of this, when they got the Ontario Securities Commission to allow speculative junior mining firms to issue something called a Preliminary Economic Assessment (“PEA”), as though most retail investors could distinguish this form of corporate disclosure from the more formal mining feasibility studies.

Those same retail investors must have been excited when Rubicon publicly announced for the first time, in June 2011, that a so-called PEA had been done on the Phoenix Gold Project. The results? 2.006 million ounces of “total mined gold to mill” according to management, AMC Mining Consultants (Canada) Ltd. and Soutex Inc. But then there’s the fine print, which is clearly disclosed by the company in its press release:

A PEA “is preliminary in nature as it includes inferred mineral resources that are considered too speculative geologically to have the economic considerations applied to them that would enable them to be categorized as mineral reserves and there is no certainty that the PEA will be realized. Mineral resources that are not mineral reserves do not have demonstrated economic viability.”

What then, is the point of the press release if the inference of the engineering work is “too speculative geologically to have economic considerations applied to” the information you’ve just released? And how did Mr. Wiseman’s CPPIB colleagues eventually lend our pension dollars against something that the company itself says is so “speculative” it can’t be relied upon to be “economically viable”?

Almost two years later to the day, Rubicon announced a new PEA, which turned up a 111% increase in the “indicated” mineral resources. This time, SRK Consulting (Canada) Inc. served Rubicon management as the independent party on the file. But that wasn’t the only change to the team. David Adamson, Rubicon’s President and CEO at the time of the 2011 report, had been replaced by Michael Lalonde. New CEO, new independent mining consultants, double the indicated resource. A successful chain of events if you sold your shares back then, I suppose.

The company’s share price rose 10% on the news. Bought deals would soon be in the wings.

Another two years passed before our retirement funds went in. On May 14, 2015, Rubicon announced it had received a US$50 million five year term loan from CPPIB Credit Investments Inc. Although the deal was a loan, then-CEO Lalonde thanked CPPIB for choosing “to invest” in his company. You can’t blame him for marketing off CPPIB’s stature. He went on to report that “mill commissioning is now well-advanced, and we have begun processing low-grade mineralized material…. We remain on schedule for projected initial gold production in mid-2015.” (CPPIB was indeed an equity investor, too, holding 3.4 million shares as of March 31, 2015.)

By the end of September 2015, Rubicon’s cash was down to $52 million, half of which was owed to suppliers. Considering the company had raised ~$270 million in the prior seven fiscal quarters (the US$50 million CPPIB loan plus proceeds from $157 million in new equity and $49 million from a gold stream facility), Rubicon’s Board and management didn’t doubt they’d demonstrate they had a fabulous gold reserve once they started to dig and process ore in volume.

But as it turns out, it was all highly speculative.

No one in the Mining Engineering fraternity had officially declared that the Phoenix Project held an attractive, mineable reserve. The stock market was definitely speculating that this particular Red Lake parcel held great promise, which is the nature of the beast. But what did CPPIB as lender have to hang their hats on?

A partially completed mill? A deed to properties in Ontario and Nevada? Residual working capital once the CCAA workout guys do their thing at some point down the road? All true. But there was no apparent business to back just yet, no free cash flow, no enterprise value. Not even proven gold reserves that could be economically mined at a certain gold price.

The parallel to the innovation economy of this particular lending situation is clear.
On every day of every week, firms such as ours, not to mention the banks, have the chance to finance pre-revenue companies. The business plans look great. Management is experienced. VCs have invested cold, hard cash in the form of equity. The market opportunity is clear, and the products or services are under development.

There’s just one thing missing: meaningful revenue.

One takes comfort, for example, from the fact that the VCs picked this one company over the 150 other opportunities they probably had for that same investment dollar. It is compelling. But in the absence of customers and meaningful revenue, the “business” is still an “idea.”

The same must be said about pre-revenue mining companies that have title to a parcel of land but no NI 43-101F1 outlining either a “proven” or “probable” mineral reserve.

I remember standing on the BMO trading floor when Bre-X’s stock re-opened after a multi-day exchange halt that followed news that the size of that gold deposit was in question. Bre-x shares fell from about $24.00 to $2.00 that dreary afternoon. Rubicon shares dropped below two cents yesterday. Although Rubicon is no market fraud, companies get dispensed with far faster now. Particularly when there are no obvious net assets to speak of. Lenders should never forget that the stock market isn’t going to bail you out of a tough deal!

All is not lost, as Rubicon isn’t bankrupt (yet). The team has engaged investment banks to sell the company’s assets. Any proceeds of that sale process may eventually find their way to the senior lender to retire our US$50 million loan in full. It all might wind up fine from a cash flow standpoint, but CPPIB will still have to answer questions about the appropriate level of risk it should be taking. If banks, both domestic and foreign, passed on the opportunity, what did CPPIB think they knew that experienced, multi-cycle resource lenders did not?

I suppose CPPIB has the luxury of burying this bit of bad news under the carpet, along with the other high profile hits they’ve taken over the years (CHC, EMI, Freescale, Neiman Marcus, SunGuard, TXU….). Some will say that any eventual haircut on a US$50 million loan is de minimus to a $273 billion investment vehicle. If that’s true, then whatever revenue CPPIB hoped to earn on that same 5 year loan was even more irrelevant to the overall performance and health of the CPP.

Some deals go sour, as every lender knows. Every institutional investor would tell you that when they happen quickly at a new fund, or if the forecast loan loss is disproportionate to the investment strategy at hand, LPs tend to hit the alarm button and redeem forthwith.

That’s certainly the reputation that Ontario Teachers Pension Plan Board earned circa 2005-07 under then Fixed Income SVP Sean Rogister, for example, when OTPPB had ~200 external managers (including 20 debt funds) advising on a decent-sized portion of their asset base. You hold your managers accountable.

The real question comes down to governance, as always, at CPPIB. Our public agency’s Board supported management’s recommendation to run its direct private debt strategy in-house. Fair enough: but are private sector conventions being followed, to go along with the private sector pay?

MRM
(disclosure: this post, like all blogs, is an Opinion Piece)