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.
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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.