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Cannabis Musings moved to Substack on May 1, 2023:
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Friends – have you been to New York City lately? It’s still a mess of unlicensed cannabis dispensaries. We talked about this a while back, and I was reminded of the problem last week when Jeremy Berke’s very excellent Cultivated newsletter (to which you should subscribe) reported on the slow rollout of dispensary licenses and openings.


To me, the whole reason we’re here is to build an industry where adult consumers are able to purchase a wide array of known, tested cannabis products in a safe environment. It’s why we put up with all of the mishigas. At the same time, there’s still a thriving unlicensed (illicit) cannabis industry competing for those same consumer dollars, and NYC is currently the epitome of that fact - you can’t swing a dead cat in Manhattan without hitting an unlicensed store or truck selling cannabis products.


Layered on top of all of this is the legacy of the War on Drugs. We talked a bit about that history a while back. Part of what drives the licensed side of the industry, particularly the push for appropriate social equity measures, is to counter the stain of that legacy. As a result, there are voices from within the licensed cannabis industry that are against criminal crackdowns on those unlicensed storefronts in NYC. (I hesitate to call out anyone in particular, hence no links.)


How does this dialectic play out, one that isn’t just limited to NYC? How do you encourage companies and entrepreneurs to spend money and time building out licensed operators, who are required to comply with regulations and only offer tested products at a material price premium, when there’s someone around the corner selling either untested or untracked product at a fraction of the price? And yet, how do you shut down the latter without considering what the War on Drugs did to so many people and acting accordingly?


I for sure don’t know the answer to that question, but I suspect that the industry ultimately won’t be able to have it both ways. At a macro level, one of the very many main reasons that the licensed industry is still so distressed is that it has a very large competitor that holds a very unfair advantage. What other product or service has that kind of problem?


I just don’t think that the licensed industry can thrive like it could or should while the illicit market is still so robust. Although lowering taxes, reducing costs, etc., would help mitigate that edge, the illicit industry would still have a major price benefit. No one needs to return to the destructiveness of the War on Drugs to solve this problem, but I don’t see it going away on its own.


I recognize that I could be completely wrong about this (hence this newsletter never being legal advice), but I think the industry can’t have its infused cake and eat it too.


Be seeing you!

 

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.


Friends – a couple of updates. First, you may recall that, back in the halcyon days of January, these Cannabis Musings offered up some predictions for this year, one of which was that hemp-derived Delta-8 THC’s days were numbered:


I do expect we’ll see something interesting when the 2018 Farm Bill (which descheduled hemp) comes up for renewal this year. If the draft Hemp Advancement Act filed by Rep. Chellie Pingree (D-ME) last February has any legs, I’m guessing that the hemp-derived THC (e.g., Delta-8) “loophole” (I put that in quotes because I don’t think the law allows for these products (no loophole), but that’s not legal advice and I recognize that many disagree with this take) will be finally be fixed.


Well, MJBizDaily just reported that U.S. Rep. Earl Blumenauer (D-OR) seems to be of the same mindset:


[S]ome members of Congress as well as the public recognize that the minority leader bears responsibility for the delta-8 situation – and that the Farm Bill would be an appropriate place to fix it. “We had a breakthrough in the 2018 Farm Bill, but it didn’t provide a regulatory framework” for intoxicating hemp-derived cannabinoids, Blumenauer said. “There are real problems,” he added. “That is recognized. So I think that coming in and filling these gaps is something that shouldn’t be hopelessly controversial.”


Now, I’m not going to claim that Rep. Blumenauer is a reader of these Cannabis Musings, but I’m not not going to claim that either.


Second, I spoke with a reader about our discussion last week and whether the challenges for distressed investors and lenders also apply to acquisitions. My view is a bit contrarian, at least based on what I’ve been reading and hearing lately.


The conventional wisdom is that we will see larger companies strategically buy up small, distressed companies because they can do so cheaply (if you want to impress your private equity friends at a party, you can tell them this is known as a “tuck-in acquisition”), or a savvy investor will create a new holding company to buy up and integrate numerous distressed companies for scale (what’s referred to as a “rollup strategy”).


To quote Homer Simpson, “I agree with [this], in theory. In theory, Communism works. In theory.” In reality, this is really hard to do in cannabis. If it were easy, we’d already have seen a lot of it in 2019-20, and would be seeing more of it today. But we’re not. Why? I think there are a few key reasons:

  • Regulatory Approval – getting approvals from regulatory agencies for a change of control of a licensed company takes a very long time on a good day. This certainly isn’t a barrier to getting deals done, but time equals risk, and when it may take up to a year to get all of the required approvals in order to close, things happen and valuations can materially diverge.

  • Consideration – the purchase price (“consideration,” if you’re fancy or a lawyer) for cannabis acquisitions still tends to be paid mostly in stock of the acquiror, with some cash paid, maybe. Stock prices and valuations for cannabis companies remain mired in dreck. It’s not very attractive for a buyer to have to pay out a larger proportion of its ownership to get a deal closed, even if the target is being sold on the cheap. In my career, I’ve seen many deals die because the buyer and the sellers disagreed on valuation, but even that chasm can be bridged creatively.

  • Liabilities – to me, the biggest problem holding back a robust M&A market in cannabis is liabilities. In nearly all US jurisdictions, a commercial cannabis license may not be transferred as a separate asset (I think Nevada is the only state that allows it, but, as you should know by now, this is not legal advice) - the entity that owns the license needs to be sold instead. The buyer can’t just cherry pick assets.

So, for the most part, buyers are stuck buying entities (known generally as stock deals as opposed to asset deals). When you buy an entity, all of the entity’s assets and liabilities go along as part of the entity - those don’t get left behind anywhere (you could try to move out liabilities before closing, but then you risk causing a “fraudulent transfer”, and anything with the word “fraudulent” in it is almost certainly bad (also not legal advice, but good advice for life generally)).


Sure, the buyer could get an indemnity from the sellers of the entity (basically, a guarantee to pay back the buyer for any losses relating to certain liabilities), but the buyer needs to get comfortable that the sellers are going to be around with cash when a claim is made (which also gets harder when the consideration is mostly stock). Based on my experience of nearly 25 years of deals, relying on individuals (which most of the sellers in cannabis still are) to be creditworthy indemnitors and unsympathetic lawsuit defendants is narishkeit.


Given all of this, buyers are going to be extremely picky before they get stuck acquiring all of the liabilities and problems that caused the distress in the first place, having to spend their very expensive resources (cash) to manage those liabilities, diluting existing owners at low valuations, and risking regulatory approval delay.


So, what’s my contrarian view? Simply that, for all of these reasons, I don’t think there really will be very much distressed M&A in the cannabis industry at all. Sure, it’ll happen, and there will be situations where the deal makes sense (and, of course, friendly neighborhood advisors such as Hauser Advisory can help figure that out), but I think those will be few-and-far-between, and not nearly as much as many other industry observers suggest.


I hope for the industry’s sake that I’m wrong.


Be seeing you!

 

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.



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!

 

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.


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