Cannabis Musings - February 14, 2023

Friends – I’ve had a number of conversations lately with investors who are trying to figure out how to take advantage of the cannabis industry’s financial distress (which we’ve talked about here recently).

I learned about the fine art of distressed investing and restructuring during my years working with Sam Zell and his team, who was one of the early machers practicing this alchemy and is known as “the grave dancer” as a result. Much of what makes that alchemy happen doesn’t really work in cannabis, making distressed investing much harder to pull off. Bear with me here.

Let’s say I’ve got a THC-infused knish company, NoshCo. I founded NoshCo a few years ago, took it public on a Canadian stock exchange, built out manufacturing and distribution in a few US states, and borrowed money from a lender that took liens on all of NoshCo’s assets. Now, with demand for THC-infused knishes waning, NoshCo desperately needs cash to pay its suppliers, and NoshCo’s creditors won’t take payment-in-kind (i.e., knishes).

Gimpel is a distressed investor with very deep pockets and a high tolerance for risk. Gimpel loves the knish edible idea and knows its long-term potential, and so wants to help bail out NoshCo (a mitzvah of a sort) while also gaining some measure of control (why would Gimpel trust me to turn NoshCo around?). How would that work? Consider some options:

• NoshCo could sell new stock to Gimpel, but with NoshCo’s stock trading at all-time lows like its US operator peers, NoshCo would have to issue a lot of stock to Gimpel in order to raise enough money, meaning that existing stockholders would be greatly diluted and the stock price would drop immediately to reflect that dilution. Also, Gimpel probably likes to control their own destiny, so being a small stockholder of a small public company, even if they get a board seat, isn’t terribly attractive.

• Gimpel could lend money to NoshCo, enough to allow NoshCo to pay off its existing secured lender and key suppliers. However, Gimpel would likely demand a very high interest rate for this rescue financing, as well as “warrant coverage,” meaning warrants for NoshCo stock that’ll provide an equity return if that stock price ever goes back up. That interest rate could be too much for NoshCo to handle in the long-run (or even the short-run).

• More critically, as a lender, Gimpel would be much more limited in their ability to steer the direction of the company (Gimpel could possibly sit on the board, but that’s fraught with the kinds of potential conflicts of interest and fiduciary duty issues that give corporate lawyers tsuris).

• Gimpel could try to take NoshCo private, buying all of the public stock (a “tender offer”). At first glance, this sounds like a great idea – with the stock price at record lows, the company is cheap. However, this is not an inexpensive undertaking – the lender will almost certainly need to be paid off at the closing of the acquisition (usually, borrowed debt becomes due when there’s a change of control), there will be millions of dollars in legal and banker fees, investors will sue because someone always sues claiming the price is too low, and NoshCo will still need to deal with its other creditors.

• Gimpel could buy NoshCo’s secured debt.

Let’s unpack this last one a bit more, because the basic idea is generally known in finance as a “loan-to-own” strategy. The investor buys up the debt, usually at a discount (either because the debt is trading and the market price has dropped, or because the lender would rather get most of its money back rather than risk a total loss).

Then, as the company’s largest creditor, the investor tries to get the company to file for bankruptcy in a pre-wired deal (known as a “pre-pack”) that would swap the investor’s debt for most/all of the equity of the company, and, depending on the circumstances, manage (or potentially wipe out) much of the company’s other debts. I’m really simplifying this, and there’s endless permutations of this basic idea, but the gist is the same – buying the debt to get control.

Gimpel’s plan is to reach out to NoshCo’s secured lender, buy the debt at a discount, and then negotiate with NoshCo’s board. Gimpel would even be willing to commit to fund money into NoshCo for operations as part of the deal. And yet, here's the proverbial raspberry seed in the wisdom tooth of Gimpel’s plan – Gimpel can’t run NoshCo through bankruptcy. The loan-to-own can’t be perfected as a result. So, here’s Gimpel, holding a pile of debt owed by a specialty knish company. What then?

Gimpel could just wait until the loan matures (becomes due), and if NoshCo can’t repay the loan, Gimple could simply foreclose on the assets and, as a secured lender, basically take the company. However, this being the cannabis industry, that’s not so simple. Before Gimpel may take title to NoshCo’s commercial cannabis licenses and goods, Gimpel is going to need state (and maybe local) approval to transfer ownership. Gimpel doesn’t have that kind of time.

Gimpel’s could also negotiate with NoshCo to convert the debt into NoshCo stock outside of bankruptcy, but this too is fraught with problems:

• Depending on the amount of the debt and NoshCo’s market capitalization (basically, the number of shares x the stock price), this could result in Gimpel taking ownership of much, if not nearly all of the company.

• NoshCo’s stock exchange probably has a rule requiring NoshCo’s stockholders to approve large stock issuances. Why would the stockholders approve the massive dilution that would result from Gimpel’s gambit? Without the threat of bankruptcy, it’d be better to hold onto the stock and ride it out as a legacy stockholder rather than giving it all away to Gimpel.

• Gimpel would be left owning (very likely) most of the stock, but won’t be happy having to deal with all of those pesky legacy stockholders who are now very cranky from being massively diluted. NoshCo could maybe then conduct a reverse split of its stock (meaning exchanging, say, 1 share for every 1,000 issued), resulting in all of the legacy stockholders owning fractional shares that are then cashed out by NoshCo (that’s a thing, sometimes), but that’s almost certainly guaranteeing a stockholder lawsuit.

• The stockholders are going to sue anyway, either to block the transaction, or to fight about the conversion price, or for damages after the fact. Who wants to pay those lawyer bills? Does the Board of Directors have sufficient D&O coverage for such a lawsuit?

• There could be significant tax consequences to converting the debt to equity outside of bankruptcy (something I always tell clients to check before doing anything else).

• Gimpel also would still need to invest additional cash into NoshCo in order to pay the trade creditors, who would be understandably nervous about all of this.

• Gimpel still needs to deal with the change of control of NoshCo’s cannabis licenses anyway.

Oy vey. There really are few good options for NoshCo and Gimpel.

That in a nutshell is why the industry is so financially challenged at the moment. None of the usual tools available to companies and investors for handling financial distress work like they’re supposed to in cannabis. Cannabis companies don’t get the benefits and investors don’t get the protections, unless they’re both willing to take on significantly more risk.

It's a problem.

Be seeing you!

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Hauser Advisory provides advice and strategy on business lifecycle events and cannabis industry navigation, tapping into a deep, national network

and 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.

Cannabis Musings - January 30, 2023

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!

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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.

Cannabis Musings - January 24, 2023

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.