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Friends – first, a quick note on the news that the FDA, after years of pondering, has decided to not issue any regulations on hemp-derived CBD, and instead let Congress do something about it. Apparently, yelling tuches ahfen tish didn’t do the trick. One can only see the humor in this result.


It will be interesting to see how the hemp industry reacts to this (lack of) news. The 2018 Farm Bill, which legalized hemp in the first place, will be renewed in 2023 and possibly cleaned up, so we’ll see if lobbying efforts shift towards Congress. Separately, I wonder how this will change the CBD products category. With the FDA punting, will companies presume that Congress will be more lenient than the FDA ever would have been, changing the risk profile for larger CPG to enter the space?


Moving from the ridiculous to the sublime, California dropped its own dose of reality by jumpstarting the inevitable transformation of the national cannabis marketplace through interstate commerce. As reported on Monday, California’s Department of Cannabis Control (DCC) sent a lengthy letter to the State’s Attorney General’s office requesting a legal opinion whether interstate commerce “will result in significant legal risk to the State of California under the federal Controlled Substances Act.” In other words, could the State of California allow its citizens to commercially export and import cannabis products and not get the State in trouble with the Federal government?


In my opinion, this is a really big deal. We’ve been talking for years about the problem and inevitability of interstate commerce, because I really do believe that, once state lines open up, the entire cultivation market will never be the same. On the one hand, there will likely be a race to the bottom for the lowest-cost supply, but on the other hand, there will be an ocean of premium products and strong brands available to meet consumer demand. In other words, eventually, when the market finally adjusts, it’ll work like any other wholesale supply chain.


Currently, all of these state laws exist to protect their commercial citizens from outside product, and whether that’s right or wrong from a policy perspective, those laws are most likely unconstitutional (not legal advice). That’s the argument in the Jefferson Packing House lawsuit filed in Oregon in November, which is challenging that state’s barriers to interstate commerce on federal constitutional grounds (i.e., the Dormant Commerce Clause).


What the Oregon case means is that, regardless of California’s next steps, the federal courts could strike down all of these state laws and regulations anyway. Who knows if California is proactively trying to get ahead of the courts (if the Oregon case were appealed, that federal appellate court’s decision (the Ninth Circuit Court of Appeals) could be binding on California as well because California falls under the jurisdiction of Ninth Circuit) by getting its own framework into place. From the State’s perspective, I imagine it’s better to regulate first rather than play catchup.


Even if the California DCC gets its legal opinion to allow interstate commerce, it then has to find another state to play along, and, as a practical matter, that state would probably need to be adjacent (How would you get products to a noncontiguous state? Air travel is under Federal jurisdiction). What other states are going to want to do the same, particularly if they are limited license? And which companies are going to want to take advantage of open borders? Some will only see upside, but it’s the cultivators and manufacturers that need to be thinking long and hard about the effects of this.


No matter what, all of this is going to take a lot of time – states don’t move quickly, nor do courts. At the same time, I’m hoping that this announcement serves as a wakeup call to the industry. I’ve advised companies about this issue before, and I expect that’ll increase as the inevitability of this change becomes more of a reality and operators think about how they’re going to adjust to survive and thrive. There isn’t one simple solution that fits every company, but open borders will impact everyone in the industry.


I’m usually not good at predicting things, but this one, dos hartz hot mir gezogt.


One last thought - perhaps also this could be another motivator for the industry to come together around a coherent, single lobbying strategy for federal legalization. To me, opening up state borders is a bit of a thumb in the eye towards Congress, in a good way.


Be seeing you!

 

Hauser Advisory provides advice and strategy on business lifecycle events and cannabis industry navigation, tapping into a deep, national network and nearly twenty-five years of dealmaking and capital markets experience.


© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form. Subscribe to Cannabis Musings at hauseradvisory.com.


Friends – before we get into this week’s Cannabis Musings, make sure to check out my lovely chat with Kevin McLaughlin, Managing Director and Cannabis Practice Leader at Centri Business Consulting. We talked about cannabis capital markets and distress, and pretended like we could predict the future.


As a coda to last week’s discussion about distress in the cannabis industry, I thought it might be helpful to look at two different signals that public markets are sending about what’s happening.


First, let’s return to Ayr Strategies, a US-based MSO. Back in the halcyon days of September 2022, we talked about how Ayr’s notes were trading below par. As a reminder, Ayr had borrowed money from investors in the form of notes (a term of art that’s practically interchangeable with “loan”, but while notes are only a promise by the borrower to pay back borrowed money (and so are more commonly the form of investment vehicles), loans tend to be also binding on the lender (and so are more commonly issued by banks)), and those notes are traded on the Canadian Securities Exchange sort of like Ayr’s stock. Back in September, those notes, which were originally issued by Ayr at 100 (generally meaning 100 cents on the dollar), were trading at 90, meaning one could by $1,000 principal (face) amount of notes for $900.


Now, those same notes have traded down to 70-71, after hovering around 80 for a while. Assuming markets are efficient (generally meaning this market is properly setting prices based on all available and relevant information), this generally means that traders think that, if Ayr were sold/liquidated today, noteholders would recover $710 for every $1,000 of principal (face) amount of the notes. In other words, these notes are “distressed” securities. It also means that a buyer of these notes at 71 that gets paid back at maturity in December 2023 will enjoy an effective interest rate (known as “yield-to-maturity”) of around 30% per annum – this is because the 10% coupon (interest rate) on the notes is paid periodically by Ayr on the full $1,000 face amount, not on the $710 (71) paid by the buyer. This is definitely not investment advice, but simply a way of illustrating how traders of these notes are pricing (viewing) the risk of Ayr not being able to pay back these notes in full by maturity.


Second, consider the pending merger between US MSOs Cresco and Columbia Care, a $2bn combination announced back in March 2022. When two public companies agree to merge, they typically value the transaction at the time they sign the merger agreement, meaning they also set their relative prices the stockholders are paying for each other based on the closing share prices right before the merger agreement date. The press release from March 23, 2022 explains this math in the Cresco/Columbia Care deal.


So, let’s say my public CBD knish company (“KnishCo”) agrees to merge with a public CBD latkes company (“LatkesCo”) into a starchy CBD powerhouse. We agree that KnishCo is worth $100 and LatkesCo is worth $50, so the combined company is worth $150. KnishCo stockholders will get 2/3 of the merged company’s stock and LatkesCo stockholders will get 1/3 (I’m keeping this simple). Assuming that LatkesCo had 10 shares outstanding and its stock was trading at $3.00 per share before the merger was announced, the deal values those shares at $5.00 (1/3 of the $150 combined company across 10 shares outstanding).


As soon as the deal is announced, the stock prices of both KnishCo and LatkesCo will trade close to the relative splits of value that each will receive in the merger, because the market assumes that the deal will close. So, traders will trade up the price of LatkesCo to just below $5.00. The difference between the market price and the merger price ($5.00), referred to as the “deal spread” or “merger arbitrage”, is evidence of how the market is viewing whether the deal will actually close and the LatkesCo stockholders will actually receive their $5.00 of value per share (again, assuming an efficient market). If the market thinks that there’s a strong likelihood that the deal will close, LatkesCo’s stock will trade very close to $5.00. If the market thinks there’s material risk the deal won’t close, the stock will trade lower (akin somewhat to bonds/notes trading below par, pricing in the risk they won’t be paid back in full).


What creates that risk is that there’s a whole shmear of things that need to happen before closing, particularly regulatory approvals. In the case of Cresco/Columbia Care, it’s the states approving the ownership transfers of the underlying commercial cannabis licenses, an outcome the two companies don’t fully control. There’s always a risk licensing authorities reject the transfers, as well as the risk those approvals aren’t granted in time before the merger agreement’s termination date (which appears to be March 31, 2023).


So, when traders think that there is a real risk that a particular deal won’t close, markets price the company’s stock away from the merger price (value), meaning the deal spread gets larger. As Viridian Capital Advisors notes in its most recent and always excellent Deal Tracker, the deal spread on the Cresco/Columbia Care has widened dramatically since December, meaning that the market thinks that there is significant risk that the deal doesn’t close (and the prices of both stocks will drop).


The Ayr note distressed pricing and the Cresco/Columbia Care widening deal spread suggest that public markets are assuming the worst (again, not investment advice). Granted, one need only look at share prices generally over the past year to draw the same conclusion, but these are two very specific data points about risk of future outcomes (yes, stock prices may also be based on expected value of future cash flows). In other words, they’re sending a signal that they think the industry is still deep in the dreck.


Be seeing you!


Hauser Advisory provides advice and strategy on business lifecycle events and cannabis industry navigation, tapping into a deep, national network and nearly twenty-five years of dealmaking and capital markets experience.


© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form. Subscribe to Cannabis Musings at hauseradvisory.com.


Friends – the fact that US cannabis companies can’t file for bankruptcy has created a really interesting dynamic over the past few years. For background, the US federal courts made it clear in 2019 that plant-touching companies may not file and take advantage of the bankruptcy code’s protections such as staying litigation, a process to restructure and resolve claims, and the ability to wipe out debt. State laws (remedies) such as receivership and assignment for the benefit of creditors don’t offer much in the way of relief – they’re at heart just mechanisms to pay off creditors. Bankruptcy is a luxury that cannabis can’t enjoy right now.


When the industry fell into distress in 2019, after the salad days of 2017 and 2018 during which you couldn’t swing a dead cat without hitting an investor willing to throw millions at a pre-revenue cannabis business (I wrote a brief history of this history back in 2020), companies that were out of money and deeply in debt couldn’t take the usual route of filing for bankruptcy to deal with their debts. Instead, companies either cut costs dramatically, negotiated terms with creditors, and hoped for the best; or shut down and hoped to not get sued by creditors. They were stuck.


Let’s then turn our attention then to Flower One Holdings, a Nevada-based cultivator. Although the operating company is a US entity, its publicly-traded parent company is a Canadian entity that filed for the Canadian equivalent of bankruptcy in October 2022. Its restructuring plan, approved in late December, entirely wiped out the public equity and effectively handed over ownership of the company to creditors (note that I’m skipping over a lot of detail). You may be wondering how Flower One could do what other US-based operators that have publicly-traded Canadian parent companies (which is how all of the Canadian exchange-listed US companies are structured). That’s a great question!


Crucially, Flower One had a Canadian parent company, which only US operators with stock trading on Canadian exchanges also have. Second, Flower One appears to have had a significant amount of debt owed by the Canadian parent entity to actually restructure. Debts owed only by the US operating subsidiaries appear to have been unaffected, which makes sense because the Canadian process can’t affect any debts in the US. Third, as best I can tell from the docket, before they filed, they came to agreement with key lenders to the Canadian parent company on the outcome of the restructuring. This is known as a “prepack,” - the primary senior lender with claims against Flower One’s Canadian parent agreed to swap that debt for the equity of the company.


Even with all of that, Flower One still needs to deal with its US creditors (again, because those debts weren’t affected by the Canadian bankruptcy). In order for this to work, Flower One’s management team and new owner (that senior lender) will need to have a plan to manage those remaining US debts. This, I think, is what makes Canadian bankruptcy likely useless for most other US operators with Canadian parents – in general, they tend to have the bulk of their debts at the US subsidiaries, not at the Canadian parent. Again, I’m skipping a lot of detail, and also none of this is legal advice, but Flower One pulled off something that few thought was possible – a Canadian bankruptcy to restructure a US-based operator.


Another interesting example of restructuring is playing out in the California flower market. Aaron Edelheit of Mindset Value just posted an excellent analysis of the decline in cultivation in the state in 2022, resulting in a current inventory shortage and increase in prices after a fairly long-term decline due to overproduction. He notes that canopy has dropped by a meshuggah 14 million square feet, or 17%, since March 31, 2022, about nine months, due to licenses being abandoned and not renewed. Although there are a number of reasons for nonrenewal, I don’t think it’s unreasonable to assume that much of that may be attributed to the fact that flower prices were uneconomically low for so long. That cutback has apparently made a difference – Aaron notes the resulting meaningful uptick in flower prices. It will be interesting to see if this happens in other states with an overabundance of cannabis flower (e.g., Michigan), and whether we also see a similar retraction in other parts of the supply chain.


The typical rules of the workout game don’t fully apply in the cannabis industry (a maxim that may fairly be said of nearly everything in the industry). It requires a dose of pain that’s unexpected by everyone. It also forces lenders and investors to rethink their strategies and underwriting. I suspect we’re going to see a lot more workout activity this year – already we’ve seen Lowell Farms announce that its pursuing “strategic alternatives” and TerrAscend converted into stock C$125 million of its debt owing to Canopy.


I’ve advised countless operators and lenders on the dynamics of workout and restructuring. The usual leverage points and negotiating tactics among creditors and owners simply don’t apply when the threat (or relief) of bankruptcy doesn’t really exist. Nothing in cannabis is easy.


Be seeing you!


© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form. Subscribe to Cannabis Musings at hauseradvisory.com.


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