Current State of Debt Financing in the Cannabis Industry
As you know from coverage in previous issues of the EDGE Briefing until recently the cannabis industry has been capital constrained. In an industry without safe banking and even federal legalization protection Mergers and Acquisitions have been the primary way to accelerate growth. Unless, that is, a cannabis operator went out to each individual legal state to go through the arduous and expensive process of complying with state licensing and local ordinance requirements. Toward the end of last year, however, the industry reached a turning point in access to capital when a syndicate of lenders provided Curaleaf with a $300 million term loan. At the time, this was the largest and most significant debt financing a Multi-state Operator (MSO) was able to negotiate. Through May, as reported Viridian Research capital raised in the cannabis industry totaled over $6.6 billion, compared to only a little over $2.3 billion in 2020. And, as the closing of the public offering by HEXO Corp (TSX: HEXO)(NYSE: HEXO) of $360 million in senior secured convertible notes indicates, debt will play a significant role in the capital flowing into the industry this year.
Cannabis Industry Turns to Debt Financing
While the industry has been capital-constrained, borrowing against assets has been a key source available for many cannabis companies to pursue. Vertically integrated cannabis companies often have significant real estate and other assets that can be leveraged. What has changed now, though, is that more debt providers have come online over the past couple of years addressing a range of needs. This means that cannabis companies now can refinance at more attractive rates. Significant developments:
- As referenced above, HEXO Corp. (TSX: HEXO)(NYSE: HEXO) closed a public offering of $360 million principal amount of senior secured convertible notes maturing May 1, 2023. Proceeds will fund the $331 million cash payment in HEXO’s $766 million acquisition of Redecan in Ontario, the largest private Canadian LP.
- In 2020, large MSOs Curaleaf and Cresco Labs announced their debt raises of approximately $300M and $200M, respectively, illustrating the capital available at the high-end of the market at that time. Then, on January 11 this year, Curaleaf has again secured a new round of financing – a $50 million secured revolving credit facility with a three-year term. Curaleaf will be paying a 10.25% interest rate for funds when needed. This is significantly lower than the interest rates cannabis companies paid for loans in previous years when the likelihood of progress on easing Federal regulations did not look as promising.
- When its stock was floundering in 2020, Acreage Holdings was able to raise debt with the credit arm of an unidentified institutional investor, for up to $100M; as opposed to further diluting equity at their weak stock prices at the time.
- Chicago-based MSO Green Thumb Industries raised $217 million through the issuance of senior secured debt to retire existing senior secured debt and for “growth initiatives.” With an interest rate of 7% per year for the maturity date of April, 2024, Green Thumb describes this transaction as industry leading.
- Toward the end of 2020, Holistic Industries, a U.S. privately held, vertically-integrated cannabis company, closed an oversubscribed round of $35M in debt for expansion and the potential of acquiring distressed assets.
FYI, what is the law prohibiting “plant-touching” cannabis businesses from obtaining a loan from a federally chartered bank or credit union?
The Comprehensive Drug Abuse Prevention and Control Act, 21 U.S.C. §§ 801, Et. Seq (1970) prohibits “manufacture, distribution, and dispensation” and any transfer or deposit of monies yielded from cannabis sale may be deemed “money laundering” in violation of the Currency and Foreign Transactions Reporting Act, 31 U.S.C. §5311-5330. Current State of Debt Financing
Debt Financing in Cannabis, What are the Options?
Sale and Leaseback Transactions
- While Sale-Leaseback (SLB) transactions aren’t technically debt they do allow companies to free up liquidity from their balance sheets without dilution. An SLB is the sale of real-estate assets to a buyer who then leases them back through a long-term lease. The upside of this alternative is that large cannabis companies increasingly have been selling their cultivation, processing and storage facilities and immediately leasing them back as a way to instantly raise tens of millions of dollars. The potential downside is that an SLB locks the asset seller into a long commitment than other straight debt alternatives that now are likely to be able to be secured for rates similar to the SLB. It should be noted, however, that in common debt transactions lenders will be looking for more than a mere promise to repay. A security interest and/or corporate or personal guarantee will most likely be required.
- Based on the valuation of real estate and equipment assets, a cannabis company can typically borrow from within the range of 40% to 75% of asset value. In the case of development projects, the loan is usually based on project costs. While less typical, there are some working capital debt options in the market as well; though the availability of this option is much less than for real estate and equipment financing.
- Up to this point, most debt financing by cannabis companies was found in convertible note options with low conversion premiums – which essentially delay dilution of equity. The company creates a note that converts to equity, often preferred stock, at a future date based on a future valuation method. These notes, similar to promissory notes with interest payable on or before a maturity date, have given investors security that they are repaid before equity holders if something goes wrong. For both the investor and the company this note structure allows the valuation question to be answered in the future while providing needed capital to the company and a more secure instrument to investors.
- Events triggering “conversion” include:
- loan outstanding beyond its maturity date;
- company raising defined capital amount in priced equity round;
- sale of company; or
- change in “control” (ex, change in entity’s effective control or ownership; sale of a large portion of company’s assets).
MTN – Short-Term Solution to Minimize Dilution with Funding at Single Digit Rates
- True, that the three alternatives listed above are considered the standard. Now, however, a new alternative is emerging, the Medium Term Note (MTN) for companies with relatively strong balance sheets. An MTN is an alternative to traditional long-term and expensive short-term financing – to aid a company with such objectives as accelerating a growth strategy, facilitating a roll-up M&A strategy.
- An MTN is essentially a bond issuance through investment bankers and funded by private institutional sources, in the range from $20M to $100M+, with specific characteristics to facilitate being issued quickly in order to take advantage of temporary market opportunities.
- The key is to effectively customize the MTN with characteristics most advantageous to the issuer that appeal to the strategy of an investor. This results in rates typically lower than other forms of debt financing. With our network of institutional funding sources for MTNs we provide an overview of the funding need and the upside for investors. Then, we assist the issuer with legal, accounting, underwriting, and rating services in order to begin the preparation of the offering.
For companies seeking debt, the following are key considerations:
- Most cannabis debt providers will require personal guarantees (PG) from principals. This is always a tough decision for founders and one that carries real risk. Are you willing to PG the debt?
- What assets does the company have? Or is purchasing? Real estate, equipment, accounts receivable, other assets?
- Does the company have existing debt? And how much debt can the company take on while not taking undue risk with cash flow?
For investors who are considering lending to cannabis companies the following are key considerations:
- What are the credit scores of the principals? Is there any credit data on the company? How timely do they pay their payables, for example?
- What is the company’s existing cash flow? How realistic is the projection for future cash flow?
- How will the company use the funds? Is the use of funds realistic?
- What security will the investor have that they can recover funds if the loan isn’t repaid? PG? Cross-corporate guarantee? First lien on assets?
- Does the management team have the right experience for the type of project/company that they want to be?
- Does the company have its state and local cannabis licenses? If real estate is involved, what is the status of current local permits?
Finding The Right Fit for Your Investment Strategy
Given these considerations, here is what we take into consideration to guide the investors from our network as they examine debt financing opportunities:
Getting Down to Business Goals
The goal is always to thoroughly understand the investment needs and objectives of both buyer and seller to develop productive relationships that lead to successful transaction outcomes. The nascent legal cannabis industry is moving at high speed toward professional management with the expertise to build unique IP and brands that dominate the market. Survival tactics employed by managers who have operated in the gray market often do not translate well in the openly competitive legal marketplace.
Real Value in the Marketplace
We determine ROI potential with well-substantiated valuations. We guide operators through the vetting process our investors expect for the best opportunities from potentially high rates of return while saving time and creating valuable investor-operator relationships. And we employ the expertise of many years transacting in the cannabis industry. For instance, for plant-touching operations key in the valuation process are factors such as the number of licenses for similar operations that have been issued by a state and the types of ordinances enforced by local jurisdictions.
The Right Time / Most Advantageous Cash-Infusion Partner
The trend of increasing legalization will continue to attract more sophisticated competition and investors. Our systematic process is designed to match the right investors with the right funding opportunity – the right operators whose objectives and scalability are a fit for investors’ portfolios.
With public support for legalization and states coming out of the pandemic in their own panic for increased tax revenues, the cannabis industry is exhibiting explosive growth. The majority of states now have medical and, in many cases, adult use legalization in place and sources like Grand View Research project a US industry size of $33 billion this year, $84 billion by 2028. Through May, capital raised in the cannabis industry totaled over $6.6 billion, compared to only a little over $2.3 billion in 2020. And as more debt providers come online, recent multimillion-dollar debt funding among cannabis industry leaders shows that debt as a capital source for cannabis companies is a rational use of capital – potentially cleaning up balance sheets and enabling access to funding for expansion and/or the purchase of distressed assets coming out of the pandemic. The advent of new debt alternatives, such as the Medium Term Note (MTN) are emerging giving operators increasing options to use debt financing for competitive advantage in the marketplace.
Next Step – Category Expertise Needed
With capital finally flowing more freely into the cannabis industry there is no better time to establish your position and get your targeted business to come out a winner among those destined to struggle for survival. A talented deal team with not only debt financing experience, but also direct experience in cannabis is essential. Expectations for performance are important to clarify at the beginning of the process along with a clear understanding of the compensation the advisors will receive for the extensive services rendered. At Highway33 Capital Advisory we stand ready 24/7 to provide the guidance our clients seek.
How We Can Help
The critical factors in assessing the potential of the array of opportunities in the industry still rely on careful execution of the basics of investment analysis:
- Due diligence for understanding the full scope of the business in the industry segment being targeted.
- Analyzing the preemptive nature of the target’s business model.
- Determining the soundness of the financial statements, particularly in cases where they are yet to be audited.
- And assessing the zeal of the team charged with the task of growing a company into a multimillion-dollar operation.
At Highway 33 Capital Advisory we excel at structuring deals to meet client investment strategies in emerging 2021 opportunities with our core expertise in Cannabis along with other highly regulated markets in the fields of Pharma, Biotech, Healthcare, Agtech, Clean/ClimateTech, and CBD/hemp companies. We specialize in thoroughly vetted companies looking to drive growth and enterprise valuations through M&A, non-dilutive debt financing and/or capital investments ranging from $5M to $100M+.
Let’s talk about putting the power of this expertise to work for you as a Sell-side or Buy-side client.