Companies in the North American Marijuana index are expected to grow at 292.8% (median one-year forward revenue growth rate estimates in Capital IQ). At a time when the North American GDP is projected, by The Economist, to grow at 2.2%, the cannabis market is undoubtedly an exceptional investment opportunity. The triple-digit growth rate in Canadian and American cannabis companies has intrigued several investors (equity and debt) to explore and understand this space. There are a number of truly interesting facets in this emerging market. As finance professionals, we are fascinated about cannabis financing. Especially, about how various market dynamics are at play to shift the spotlight from equity to niche areas of debt financing and how investors can capitalize on these opportunities.
Cannabis financing in 2018
Over the last 2 years, cannabis equity investments from institutional and retail investors have been on a tear. Based on data published by the TMX, Cannabis (and cannabis related) companies accounted for 18.1% of the total equity raised in Toronto Stock and Venture Exchanges (TSX and& TSX-V) for 2018, compared to 0.6% in 2016. These percentages were much higher on the Canadian Stock Exchange (CSE), with cannabis companies accounting for 51% of the total equity raised on the CSE. Between the CSE and TSX and TSX-V, cannabis companies raised approximately $10 billion of equity in 2018.
Outsized investor demand drove cannabis valuation to exaggerated levels, at least until a point. After cannabis was legalized in Canada, the public market’s mindset seems to have shifted from ‘buy the rumor’ to ‘sell the news’ and the valuation for cannabis companies started to dip. This coupled with geopolitical uncertainties, operational concerns and yield curve inversion led cannabis companies to underperform in the last quarter of 2018. At the close of 2018, the Marijuana index had dropped by 32.8% on an annual basis.
Potential shift to non-dilutive capital?
Based on our research, 60% of the companies in the North American Marijuana index had a lower share price as of Dec 31, 2018 relative to their last round of financing. For this subset, the median share price drop was 36.4%; with a few falling as low as 75% from their last equity raise. We believe some of these cannabis companies may not fully recover in the short term. Such companies might be unable or unwilling to tap equity capital because they may not want to do a down round (i.e. future equity raise is done at a lower valuation than that of the last equity raise). This could force cannabis companies to explore non-dilutive sources of capital.
In addition, cannabis companies are currently under-levered compared to the general public markets. Based on data from Capital IQ, the aggregate debt/Enterprise Value ratio is 1.5% (defined as total debt minus convertible debt) for all the companies in the Marijuana Index. Eventually, some of the cannabis companies will turn to leverage to increase shareholders' value.
The above two factors should increase the demand for cannabis debt from current levels.
Cannabis debt - current realities
The first major cannabis debt financing (without any equity-linked, conversion features) closed in April 2017 when CIBC provided a $20MM credit facility to MedReleaf. Our sources have suggested that this was more of a relationship play and at the time, the major banks were still not fully open to work with the cannabis sector. Debt activities stepped up in 2018. Based on our research, about $1 billion was raised in significant (transactions over $10MM) North American cannabis debt, with just two major companies accounting for 50% of that value. Non-bank lenders accounted for a substantial portion of this capital.
In the North American cannabis debt market, there is a notable distinction between companies that operate in the US and Canada. On the Canadian side, so far, the debt lenders include: two Canadian banks, one credit union, and one crown corporation, offering mid single-digit interest rates. This is nonexistent for companies with US cannabis operations.
Both US and Canadian cannabis companies have access to a limited, albeit growing number of non-bank lenders. The bulk of them are asset-backed lenders charging interest rates that range between low-double digits to mid-teens, with varying levels of warrant coverage.
Another reality that is worth highlighting is the perception around licenses, which is a pivotal asset for cannabis companies. Lending against the value of the license hasn’t really taken off for many reasons. First, with the growth in the number of issued licenses, the supply side of the equation has increased significantly. Second, the value is shifting from shell companies with just a license to operating businesses. Third, the purchase price range of the transaction comps (for just the license) is quite wide and volatile, making it difficult to put a pin on its value.
Finally, regulations around security clearance and transferability of the license pose a major hurdle for lenders trying to take security over it, specifically in the US where regulations vary by state. Lenders agree that there is value to the license. Unfortunately, for cannabis companies, this intangible asset is not being considered as primary collateral.
Cannabis debt in 2019 - What to expect?
Given that several cannabis companies trade below their last equity valuation and have low levels of debt, we believe cannabis debt is poised to grow. As the debt markets react to this increased demand, multiple market dynamics will come into play:
Asset-Backed Lending: We think the initial wave could be an increase in asset-backed cannabis debt. Given the nascent nature of the cannabis sector, lenders would rely less on their industry knowledge and pivot more towards their core strength in lending against PPE, real estate, and other traditional assets. For example, lenders have started to provide construction financing to cannabis companies against the value of real estate and PPE. Given regulations about cannabis storage and sales, inventory-based financing (for cannabis oil and flower) is yet to become mainstream.
On the Canadian side, given that cannabis is legal, two key factors will impact how quickly this space grows. Firstly, lenders must be willing to look past the stigma associated with cannabis. Secondly, there is a need to understand regulations and intricacies around taking security over cannabis assets. In the US, the lenders also need to consider federal laws and navigate them accordingly.
In the short term, we believe several non-bank lenders (on both sides of the border) are likely to jump on the bandwagon. In the medium term, Canadian banks will open up to asset-backed lending but will continue to stay away from companies with US exposure.
Non-plant touching cannabis companies: This segment is emerging as a halfway point for lenders to get their feet wet before lending to the broader cannabis space when the US legalizes cannabis at the federal level. Companies in this segment include suppliers, packaging companies, systems integrators and value-added resellers that cater to the cannabis market. These companies are characterized by generating most of their revenues from cannabis companies, but do not directly touch the cannabis plant in the normal course of their business. We expect an increase in lending to this segment as well. As far as this segment is concerned, we have worked on transactions where lenders are comfortable to lend against receivables and inventory as well.
Cash Flow (CF) Lending: For lenders, this segment could be the most challenging and potentially rewarding as well. The challenge stems from the fact that CF lending requires a greater knowledge of the industry and operations to assess the stability of the cash flows. Shorter track records of cash flows for cannabis companies only adds to these complications.
On the flipside, lenders who manage to untangle the complexities, might not have a lot of competition in the short term. This might enable them to get bank-style debt coverage and covenants and charge non-bank interest rates that would range between LIBOR + 8% to LIBOR + 13%, supplemented with warrants and commitment fees.
Reaping the outsized returns
The cannabis sector is a remarkable, triple-digit growth opportunity and has been the darling of the public markets for the last few years. Given recent weakness in many publicly listed cannabis companies and low levels of leverage, we believe the cannabis debt market will steal the limelight soon. We are witnessing an increasing number of non-banks (both Canadian and US) that are keen to provide asset-backed debt to cannabis and cannabis-related (non-plant touching) companies. Until full federal legalization in the US, niche non-bank lenders will continue to reap outsized returns.
Most of the pure debt funds that are active in the cannabis space are not available to retail investors. Still, there are a few multi-strategy funds, such as Canopy Rivers (TSXV.RIV), Trichome Financial Corp. (soon to be listed) and Cannabis Wheaton (TSXV.CBW) that provide exposure to the broader cannabis investment world. For the time being, these companies could enable retail investors to diversify their traditional portfolio with access to cannabis funds. We believe it's only a matter of time, before a pure cannabis debt fund opens up to the retail investors. When that time comes, investors should be ready to capitalize on it.
Author: Raj Natarajan
Supporting Research: Ben Ghirmai, Will Stuart
Source: Capital IQ, Economist – The World in 2019, TMX - MIG Reports and data from TMX Market Intelligence, and 4Front’s research
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.