The Importance of Cannabis Debt Scoring During the Capital Crunch

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Guest
Post
by
Frank
Colombo, Partner
and
Chief
Risk
Officer
of
Aspen
Finance
LLC

The
cannabis
debt
wave
is
coming!

Despite
solid
efforts
to
reduce
cash
burn,
cannabis
companies
will
require
significant
amounts
of
financing
in
2020
to
complete
their
build-outs
and
strategic
acquisitions
but…

The
equity
market
is
virtually
closed
to
a
large
swath
of
cannabis
companies.
Even
those
with
solid
business
positions
and
clear
paths
to
profitability
will
find
selling
equity
painful
at
the
new
price
levels.
Expect
to
see
a
marked
increase
in
distressed
asset
sales
from
companies
who
probably
could
have
sold
equity
in
early
2019.

The
cannabis
crash
of
2019
occurred
because
the
growth
and
margin
assumptions
required
to
support
earlier
valuations
were
too
extreme.
Investor
expectations
regarding
growth
rates,
time
to
cash
positive,
stabilized
EBITDA
margins,
costs
of
capital,
and
the
difficulty
of
eliminating
the
illegal
market,
have
been
adjusted,
and
cannabis
equities
are
now
more
fairly
priced.
The
market
may
recover
a
bit
from
here;
however,
barring
a
major
catalyst
like
full
federal
legalization
(which
doesn’t
seem
likely
in
the
near
term),
those
heady
IPO/RTO
prices
are
gone
for
good.

There
is
lots
of
room
for
debt
in
the
cannabis
capital
structures.
Debt,
including
equity-linked
debt,
like
convertibles,
accounts
for
only
12.9%
of
market
capitalization
for
the
top
25
U.S.
public
cannabis
companies:

  • Most
    banks
    and
    financial
    institutions
    are
    unable
    to
    lend
    to
    cannabis
    companies,
    and
    this
    is
    unlikely
    to
    change
    in
    2020.
    Private
    capital
    is
    increasingly
    stepping
    in
    to
    fill
    the
    void,
    driven
    by
    the
    extremely
    attractive
    returns.
  • Historically
    this
    nascent
    industry
    presented
    too
    high
    a
    risk
    for
    fixed
    rate
    investors.
    Accordingly…
  • Most
    cannabis
    debt
    has
    been
    convertible
    with
    low
    conversion
    premiums

    essentially
    representing
    delayed
    equity
    issuance.
    Many
    deals
    have
    paired
    convertible
    debt
    with
    detachable
    warrants
    for
    combined
    coverages
    of
    well
    over
    100%.
    The
    “stripped
    yields”
    (yields
    with
    conversion
    features
    removed)
    on
    these
    converts
    are
    eye-popping
    and
    the
    few
    straight
    coupon
    deals
    have
    been
    equally
    attractive.

The
credit
quality
of
the
industry
is
now
at
a
tipping
point.
18
out
of
25
U.S.
cannabis
companies
profiled
are
expected
to
be
EBITDA
positive
in
2020
(versus
8/25
in
2019),
supporting
the
inclusion
of
debt
in
their
capital
structures.
Debt
capacity
(calculated
at
3
times
consensus
estimates
of
2020
EBITDA)
is
approximately
$4
billion
compared
to
outstanding
debt
of
about
$1.8
billion
($0.5
billion
of
which
is
MedMen
alone!).

The
trend
towards
straight
debt
issuance
has
begun
with
the
recently
announced
$275
million
13%
term
loan
from
Curaleaf
and
the
$73
million
15%
senior
secured
notes
from
Harvest
Health
and
Rec.
But
make
no
mistake

only
the
top
tier
of
credits
will
be
able
to
issue
debt
without
warrants.
Pricing
for
mid-tier
credits
will
likely
improve
with
lower
warrant
coverages
and
higher
exercise
premiums.
Meanwhile,
in
the
midst
of
this
new
debt
issuance
wave,
2020
will
be
the
real
kickoff
for
cannabis
distressed
debt
trading,
complicated
by
the
unavailability
of
Chapter
11.

Don’t
look
for
any
help
from
the
rating
agencies
in
your
investment
decision

Neither
S&P
nor
Moody’s
has
issued
any
credit
rating
in
the
cannabis
market
and
neither
seems
to
be
in
any
rush
to
jump
in.
It
will
probably
take
a
minimum
of
the
SAFE
Banking
Act
before
the
agencies
get
involved.

The
accounting
can
be
byzantine,
trusted
ratios
may
fail,
and
neither
the
companies
nor
most
managements
have
much
operating
history.

Many
U.S.
investors,
who
are
not
familiar
with
IFRS
accounting,
will
struggle
with
the
dramatic
and
volatile
impacts
that
IFRS
mark-to-market
adjustments
can
have
on
gross
margins
and
inventory
valuation.
Tried-and-true
credit
ratios
like
EBITDA/Interest
and
Debt/EBITDA
may
be
relatively
meaningless
when
the
companies
have
negative
EBITDA
and
very
little
debt.
In
addition,
few
of
these
companies
have
more
than
2
years
of
operating
history.

Discerning
relative
credit
quality
through
the
smoke

A
simple
yet
robust
credit
ranking
model
will
be
a
prized
tool
for
portfolio
managers
first
dipping
their
toes
in
the
cannabis
debt
market.
I
have
developed
an
effective
model
that
is
customizable
and
incorporates
data
from
financial
statements
and
market
pricing
as
well
as
optional
user
inputs
on
qualitative
factors
like
management
quality,
regulatory
environments,
business
sector
risk,
and
competition.

The
model
produces
the
following
ranking
of
the
top
25
public
U.S.
cannabis
companies
utilizing
Q3:2019
financials
and
1/16/20
equity
prices:



About
the
author:


Frank
Colombo

is
Partner
and
Chief
Risk
Officer
of
Aspen
Finance
LLC,
a
fund
established
to
lend
to
and
invest
in
the
cannabis
industry.
Frank
is
a
seasoned
executive
with
over
20
years
of
success
in
consulting,
credit
research,
valuation,
and
financial
planning
and
analysis.
He
was
formerly
Global
Head
of
High
Yield
Research
at
UBS
and
Managing
Director/Head
of
Research
at
Seaport
Group
LLC.

He
holds
a
BA
summa
cum
laude
from
University
of
Colorado,
an
MBA
from
Stanford
University,
and
a
CFA.

Frank
is
available
for
strategy,
financial
analysis
and
valuation
consulting
and
can
be
reached
by
emailing fcolombocfa@gmail.com.


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