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.
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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.