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Considering the current disconnect between cannabis debt and equity markets

January 14, 2022
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Friends – with the recent crop of announcements showing robust activity in cannabis debt capital markets – among others, Curaleaf borrowing $425 million for 5 years at 8% through an offering (a securities and finance term essentially meaning “sale”) of senior secured notes (something I explained here), and Bespoke Financial borrowing $125 million to fund its lending activities – I thought it might be useful to expand on comments I’ve made in these Cannabis Musings recently (here and link) about the apparent dialectic that’s emerged between cannabis equity and debt markets. One of many caveats – I’m just a lawyer, so don’t expect any of this to be comprehensive, or even correct, and for sure don’t take this as investing advice.

On the one hand, borrowing has never been easier for the cannabis industry. Lending made a foothold in 2018 initially with the availability of loans and leases to finance equipment for cultivation and processing. Next came real estate lending, primarily through sale/leasebacks (where the property owner sells the real estate, and the buyer leases it back at a loan-like cost of capital, making it lending-ish) from a number of cannabis REITs (real estate investment trusts – a type of entity structure that provides enhanced tax benefits), but also straight mortgage lending from funds, and even a handful of enterprising banks. In 2019, more traditional secured lending really came into play, with non-bank lenders starting to make loans to operators and ancillary businesses secured by all assets (including licenses and inventory, which is a whole other discussion). Over time, loan offerings have become cheaper (meaning lower interest rates) and more complex (such as senior secured notes (again, explained here) and factoring (a weird finance term describing loans against receivables)).

In my mind, the rise of debt in the cannabis industry was primarily driven by two main factors. From the borrower’s perspective, cannabis businesses built a large asset base financed by capital raised through public issuances during 2017-early 2019 (I discussed this wave a while back) 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 ownership of) its investors holdings, even if its cash flow now had to also go towards paying loan interest.

From the investor’s perspective, lending against assets (real estate, equipment, and even inventory and licenses) provide a measure of downside protection (particularly given that a cannabis borrower can’t file for bankruptcy) that investment equities don’t offer, particularly in the wake of cannabis stock price declines throughout 2019. (link) When linked to equity warrants (a right to purchase stock), the lender can get a decent coupon (interest payment), with upside potential if the outperforms. As the financial health of the industry as a whole and cannabis companies individually have all improved since 2019, more investors have entered the industry (credit funds, hedge funds, and family offices) chasing loans and notes that offer good returns on a collateralized basis, particularly when compared to interest rates offered by high yield/junk bond (rated as riskiest – sort of explained here) issuers outside of cannabis. (link) In other words, institutional investors are able to get exposure to (essentially redundant of “invested in”) cannabis without as much direct risk, and, even more importantly (from their perspective), without being an owner of a cannabis company (getting into all sorts of licensing, regulatory, and compliance issues).

On the other hand, the prices of publicly-traded cannabis stocks have taken a more farpotshket route over the past four years – particularly so in 2021. So why didn’t stock investors similarly reward the industry’s strong financial performance and expanded access state access in 2021? I think there are many factors at play, including:

  • There was a fair amount of excitement among stock investors starting in the fall of 2020 about federal legalization potentially coming through as democrats won the White House and then, more importantly for the issue, took control of the Senate. As we’ve seen, that hasn’t exactly worked out as planned, and the stock market seems to have reacted accordingly.
  • Cannabis stocks are generally hard to trade for US investors because many brokers won’t execute (a finance term for “do”) trades in US cannabis stocks. This is generally for two reasons –cannabis is illegal in the US and major clearing houses won’t clear the trades. Clearing is the process by which brokers (and others) reconcile trades between buyers and sellers; clearing houses sit in the middle and facilitate this process. Brokers are concerned not only about holding stocks in illegal companies for customers, but also processing trades and handling money relating to those stocks.
  • Major clearing houses won’t clear trades in US cannabis stocks for the same reason that the brokers won’t trade them – federal illegality.
  • Also, US cannabis stocks trade on smaller Canadian exchanges – the NEO Exchange and the Canadian Stock Exchange. These exchanges don’t generally have the same level of volume and activity as larger exchanges.
  • As a result of the fact that it’s hard to trade US cannabis stocks, volume for most cannabis stocks is relatively low. Lower volume can tend to lead to larger price swings, simply because it’s harder to find buyers and sellers, so the difference between bid and ask (the price at which a buyer will buy and a seller will sell) is greater to attract the trade.
  • M&A in the cannabis industry tends to rely heavily on stock as currency. Those shares tend to be “locked up” for a period of time post-closing, meaning the sellers can’t trade them, even though they’re issued. As a result, there’s stock that’s outstanding, but not yet in the hands of the public (known as “overhang”), further limiting exchange volume and liquidity.
  • Debt is a more long-term investment that can’t be easily bought or sold. Stock investors have the luxury of capriciously reacting to minute-to-minute changes in market and industry sentiment, particularly during a time of meme stock investing.

So what does this all mean? I’m not going to answer that question, because the answer is likely going to sound like investing advice, which this very much is not. I suppose this is just an attempt to decode a curious phenomenon in cannabis capital markets, so that we now have some more tools to understand their continued evolution.