VALUATING MINING PROJECTS IN INTERNATIONAL INVESTMENT ARBITRATION

• Jurisdiction: United States

International Mining and Oil & Gas Law, Development, and Investment (April 2017)
CHAPTER 4A
VALUATING MINING PROJECTS IN INTERNATIONAL INVESTMENT ARBITRATION¹
Manuel A. Abdala
Carla Chavich ²

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CARLA CHAVICH is a Vice President in the New York office of Compass Lexecon. Ms. Chavich specializes in economic and financial analysis, and in the design of complex valuation models related to assets in developing countries. Her work is primarily focused on international arbitration matters, where she performs economic and financial analysis in the context of international treaty and contractual disputes. She has participated in more than 35 international arbitration cases, in courts such as ICSID, ICC, and UNCITRAL, and in several regulatory consultancy projects. Ms. Chavich has worked on projects related to various industries (oil and gas production, electricity generation and distribution, gas transportation and distribution, telecommunications, infrastructure, air transportation, water services) in diverse locations, including Argentina, Brazil, Bolivia, Chile, Ecuador, United States, and Venezuela. Carla Chavich is a CFA® charterholder and holds an MBA from Harvard Business School. She obtained her degree in Economics from Universidad de San Andrés with summa cum laude honors and a specialization in Finance at the same university. Prior to joining Compass Lexecon, she worked in LECG's International Arbitration group and Itaú BBA's Debt Capital Markets group. She has also been an assistant professor of economics at a post-graduate program for engineers.

CARLA CHAVICH es Vice Presidente en Compass Lexecon. Carla Chavich es MBA de Harvard Business School y posee la designación CFA®. Obtuvo su título en Economía de la Universidad de San Andrés con honores summa cum laude y una especialización en Finanzas de la misma universidad. Antes de unirse a Compass Lexecon, trabajó en el grupo de Arbitraje Internacional de LECG y en el grupo de mercados de capitales de Itaú BBA. Carla Chavich se especializa en análisis económico y financiero, y en el diseño de modelos de valuación de activos en países en desarrollo. Ha participado en más de 35 casos de arbitraje internacional, en tribunales como el CIADI, la CCI y la CNUDMI, y en varios proyectos de consultoría de regulación. Carla Chavich ha valuado proyectos en varios sectores (producción de petróleo y gas, generación y distribución de energía eléctrica, transporte y distribución de gas, telecomunicaciones, infraestructura, transporte aéreo, entre otros) en diversos lugares, como Argentina, Brasil, Bolivia, Chile, Colombia, Croacia, Ecuador, España, Estados Unidos de América, Perú y Venezuela.

This working paper explores the challenges that quantum experts face when valuing natural resources and visits the discussions raised in recent arbitration cases in the gold mining sector. First, the valuation methodologies used to assess damages are analyzed. Second, the key drivers of value that quantum experts should consider are presented.

I. Valuation Methodologies

The use of fair market value as a basis for damage compensation is standard: a fair market valuation requires calculating the price at which Claimant would voluntarily transact the disputed business under no compulsion to sell.³ This principle guided tribunals in recent mining cases who favored market and income based approaches.⁴

a. In Crystallex v. Venezuela, ⁵ the Tribunal awarded damages based on the stock market and publicly traded market multiples approaches. ⁶ The Tribunal rejected the income approach based on the P/NAV method as it did not provide reliable figures for the

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valuation date selected by the Tribunal, the indirect sales comparison method given that its results were deemed excessively speculative, and the cost approach as it did not reflect the fair market value of the project.⁷

b. In Gold Reserve v. Venezuela, ⁸ the Tribunal accepted the Discounted Cash Flow (DCF) method as the preferred valuation methodology and used the relative multiples approach based on comparable publicly traded companies and transactions to check the reasonableness of the DCF valuation. ⁹

c. In Rusoro v. Venezuela, ¹⁰ the Tribunal determined the "genuine value" of Rusoro's expropriated investment based on Rusoro's peak market capitalization, the book value and the amount invested by Claimant adjusted by a gold index. ¹¹ The tribunal rejected valuations based on the historic amounts invested, on Rusoro's market capitalization the day the expropriation was announced, and on comparable publicly traded companies and transactions. ¹²

The "Standards and Guidelines for Valuation of Mineral Properties" by the Canadian Institute of Mining, Metallurgy and Petroleum (CIM), which are considered as important standards in the industry, also recommends the application of income and market-based methodologies in cases in which the economic viability has been demonstrated by a Feasibility Study or Prefeasibility Study, including development properties that are not yet financed or under construction.¹³

A. Income Approach

Income-based approaches, such as the Discounted Cash Flow (DCF) method, provide a direct way to measure expected revenues (and their corresponding cash flows).¹⁴ A forward-looking valuation method is appropriate because it mirrors how investors assess the value of income-producing assets, especially for natural resource companies, whose value comes from their

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anticipated future production, not their past investments. In fact, the DCF method is the most common methodology used in valuation analyses involving assets in the natural resources industries (as well as most other industries).¹⁵ First, it is widely supported by professional literature, and its workings are well understood. Indeed, most investors rely on a DCF analysis to determine whether or not to undertake a particular project. Second, the DCF approach is a widely accepted method to estimate damages and fair market valuations in international disputes.¹⁶

In practice, the DCF method calculates future cash flows for the particular asset to be valued, and discounts them back to the agreed-upon valuation date. The method therefore requires several key inputs such as: revenues, extraction, investment, retirement and cleaning costs, discount rate, and terminal value, in addition to any other project-specific assumptions.

Under the DCF approach, free cash flows (FCF) are computed by netting cash inflows against cash outflows, that is, valuation experts first calculate revenues, and then deduct operating expenses and capital expenditures, and all applicable taxes. Valuation experts can net out financial debt payments (principal and interest) to arrive at the cash flows accruable to equity holders.¹⁷ FCF are then discounted to arrive at a present value at a rate that takes into account the time value of money and the risk associated to the project.¹⁸ The relevant discount rate should reflect the cost of raising equity and debt to finance the valued project.¹⁹

While the DCF method is widely used, some tribunals have been reluctant to adopt it unless the business in question had an established historical record of financial performance.²⁰ Imposing this limitation on natural resources assets, however, is counterintuitive from an economic

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perspective, since once the exploration stage is surpassed and the reserves are certified, there should be little doubt that reserves can be monetized into future cash flows.

Net Asset Value (NAV) Method

In the gold mining sector, investment analysts and banks typically use a modified version of the DCF known as the Net Asset Value method (NAV), which is then adjusted by a "P/NAV" multiple.²¹ The NAV follows the same structure and logic of a DCF method, with two typical assumptions: use of a pro-forma, or standardized discount rate, and use of constant gold price to forecast free cash flows in constant terms.

These assumptions used in the gold mining industry are mostly the result of the uniqueness of gold as a commodity. Apart from its industrial uses, gold has a long history of being perceived not only as a universal currency, but also as a safe haven in times of political and financial turmoil. Its role as a safe haven implies that the price of gold tends to rise when stock markets and the macro-economy falter.²² Gold mining companies, then, have value not only in their role as production companies but as holders of resources which are considered and priced as store of value and safe haven relative to other investments. Furthermore, since the correlation between the price of gold and the performance of the stock market is unstable (negative correlation in times of crisis, none or positive in normal times), gold mining companies have particularly unstable market betas, making the computation of a cost of capital in a "build-up" fashion extremely time sensitive, and thus more volatile.²³

Financial analysts tend to rely on pro-forma discount rates which are ultimately implicitly adjusted to market conditions through a yardstick analysis of value relative to other companies through the P/NAV ratio. Practitioners derive a company's P/NAV ratio as its market capitalization (P) divided by its NAV, and use that P/NAV ratio to compare to other companies' P/NAVs. The market usually values the company at a premium or a discount over the standardized NAV considering the particularities of the project or difference in analyst's assumptions. For example, a company with attractive features and value potential might be assessed at P/NAV ratio of 1.5, meaning a market value that is 50% higher than a company with a similar NAV. A company with less attractive features, on the other hand, might be assessed a P/NAV of only 0.8, meaning that its market value is below its NAV.

If a company is not publicly traded, the market capitalization of a target company can be derived...