Considering the current disconnect between cannabis-related debt and the stock markets
Friends – with the recent crop of announcements showing robust activity in the cannabis debt capital markets – among others, Curaleaf borrow $ 425 million over 5 years at 8% through an offer (a securities and financing term essentially meaning “sale”) of senior secured notes (something I explained here), and Tailor-made financial borrowing $ 125 million to fund its lending activities – thought it might be helpful to expand on the comments I made in these Thoughts on Cannabis recently (here and link) about the apparent dialectic that has arisen between the cannabis stock and bond markets. One of the many caveats – I’m just a lawyer, so don’t expect this to be all complete, or even correct, and certainly don’t take this as investment advice.
On the one hand, borrowing has never been easier for the cannabis industry. Credit first gained a foothold in 2018 with the availability of loans and leases to finance cultivation and processing equipment. Next come home loans, mainly through sale-leaseback (where the owner sells the property and the buyer re-leases it at a loan-like cost of capital, making it a loan) from ‘a number of cannabis REITs, real estate investment trusts – a type of entity structure that offers increased tax advantages), but also direct mortgages from funds, and even a handful of enterprising banks. In 2019, more traditional secured loans really came into play, with non-bank lenders starting to provide loans to operators and ancillary businesses secured by all assets (including licenses and inventory, which is a whole different story). discussion). Over time, loan offers have become cheaper (i.e. lower interest rate) and more complex (such as senior secured notes (again, explained here) and factoring (a strange financial term describing loans against receivables).
In my mind, the increase in debt in the cannabis industry was mainly due to two main factors. From a borrower’s perspective, cannabis companies have built up a significant asset base funded by capital raised through public issues during 2017-early 2019 (I discussed that wave a while ago) that could be used as loan collateral (which is the whole idea of leverage). Companies could now finance growth without having to further dilute (reduce the percentage of ownership) their investors’ holdings, although its cash flow now also had to be used to pay loan interest.
From an investor’s perspective, loans for assets (real estate, equipment and even inventory and licenses) offer a downside protection measure (especially given that a cannabis borrower cannot file for bankruptcy) that investment stocks are not offering, especially in the wake of the decline in cannabis stock prices throughout 2019. (link) When tied to equity warrants (a right to buy shares), the lender can get a decent coupon (interest payment), with upside potential if it outperforms. While the financial health of the industry as a whole and individual cannabis companies have all improved since 2019, more and more investors have entered the industry (credit funds, hedge funds and family offices) at looking for loans and notes offering good returns on a collateralized basis, especially compared to the interest rates offered by high yield / junk bonds (valued as the riskiest – somehow explained here) issuers other than cannabis. (link) In other words, institutional investors are able to gain cannabis exposure (essentially redundant of ‘invested in’) from cannabis without as much direct risk, and, more importantly (from their perspective), without owning a cannabis business (getting all kinds of licensing, regulatory and compliance issues).
On the other hand, the prices of publicly traded cannabis stocks have taken a higher turn. farpotshket route over the past four years – especially in 2021. So why haven’t equity investors rewarded the industry’s strong financial performance and expanded state access equally in 2021? I think there are several factors at play, including:
- As of fall 2020, equity investors were very excited about the potential federal legalization as Democrats won the White House and then, more importantly for the matter, took control of the Senate. as we have seen, it didn’t exactly go as planned, and the stock market seems to have reacted accordingly.
- Cannabis stocks are generally difficult to trade for US investors, as many brokers do not execute (a financial term for “doing”) transactions in US cannabis stocks. This is usually due to two reasons: Cannabis is illegal in the United States, and the major clearing houses do not clear transactions. Clearing is the process by which brokers (and others) reconcile transactions between buyers and sellers; clearing houses are in the middle and facilitate this process. Brokers are concerned not only with holding stocks in companies that are illegal for clients, but also with processing transactions and managing the money associated with those stocks.
- Major clearing houses will not allow trading in U.S. cannabis stocks for the same reason brokers will not trade them – federal illegality.
- Additionally, U.S. cannabis stocks trade on smaller Canadian exchanges – the NEO Exchange and the Canadian Exchange. These exchanges generally do not have the same level of volume and activity as the larger exchanges.
- Due to the fact that it is difficult to trade cannabis stocks in the United States, the volume of most cannabis stocks is relatively small. Lower volume can tend to lead to larger price fluctuations, simply because it is more difficult to find buyers and sellers, so the difference between supply and demand (the price at which a buyer is will buy and a seller will sell) is greater in attracting trade.
- Mergers and acquisitions in the cannabis industry tend to rely heavily on stocks as a currency. These stocks tend to be ‘locked in’ for a period of time after closing, which means that sellers cannot trade them, even if they are issued. As a result, there are shares in circulation, but not yet in the hands of the public (called “overhang”), which further limits the volume of trading and liquidity.
- Debt is a longer term investment that cannot be easily bought or sold. Equity investors have the luxury of reacting capriciously to minute-to-minute changes in market and industry sentiment, especially during a period of equity investing.
So what does all this mean? I’m not going to answer this question because the answer will likely sound like investment advice, which it isn’t at all. I guess this is just an attempt to decode a curious phenomenon in the cannabis capital markets, so that we now have additional tools to understand their continuing evolution.