A Search for Yield – Cannabis, Capital, and Credit

As highlighted in a previous blog post, a few months ago at Burns & Levinson’s Third Annual State of the Cannabis Industry Conference, several industry insiders and financial expert panelists forecasted a number of notable shifts in the cannabis capital markets to play out over the coming months.  We are now beginning to see some of those projections take form and come to fruition.  Of particular note, are the evolving patterns found in the fundraising efforts of cannabis operators and their pursuit for infusions of new capital, amidst a market segment reeling from a recent large scale financial downturn.  As sector participants descend on Boston for the 2020 Northeast Cannabis Business Conference, which kicks off today, players in the cannabis financial market would be well advised to take stock of these developments.  Of particular note is an increasing trend towards debt financing and a shift away from what has previously been an equity-investment heavy industry, exemplified by a number of high-profile transactions in the past few weeks involving several key players.

The recent dip in cannabis company valuations and related equity pricings has had a significant chilling effect on the industry’s equity markets, principally those concerning originations and initial offerings, both public and private.  This scarcity of available equity capital (at favorable prices) has led many operators to find alternative approaches to raising funds, including: (i) cost-cutting, operational consolidation, and other remedial actions, in efforts to “wait out the storm”; (ii) stock-for-stock sales to other cannabis companies; (iii) sale-leaseback transactions; and (iv) incurrences of indebtedness.  A concentration on improving operations and business efficiencies to obtain positive cash flows and stock-for-stock deals were expected, while sale-leasebacks have always been a possible source of liquidity for a broad range of businesses looking for extra cash.  However, debt financing transactions, particularly those of significant relative industry magnitude, have generally been avoided in the cannabis industry.  A major reason for this has been the ever-present specter of Section 280E of the U.S. federal Internal Revenue (tax) Code, which prevents certain expenses, including interest expense, from being deducted from a cannabis company’s taxable income.  This inability to make tax deductions for interest expense, combined with a dearth of lenders willing to advance credit to the industry (resulting in comparatively inflated interest rates), has caused many cannabis companies to shy away from seeking loans to finance their operations, capital expenditures, and acquisitions.

In large part a consequence of the cooling equity market, we are now seeing the advent of much larger debt financing deal sizes and an increasing number of well-known borrowers with household names.  Some recent examples of this latest trend include:

  • Curaleaf’s January 15, 2020 announcement of an upsize to its current “Senior Secured Term Loan Facility” that increased the debt cap of a facility it closed in December 2019. The syndicated loan, now totaling a principal amount of $300mm, bears interest at a rate of 13.0% per annum, payable quarterly, with a maturity date 48 months from the original closing.
  • Cresco Labs’ January 23, 2020 announcement of its closing on a senior secured term loan with an initial principal amount of $100mm, which can be increased to a maximum of $200mm upon the mutual consent of the lenders and Cresco. The facility will bear interest at a rate of approximately 12.7% per annum for 18-month loans and approximately 13.2% for 24-month loans, payable quarterly.
  • Acreage’s February 7, 2020 announcement that it had entered into definitive documentation to secure financing via three related transactions, as follows:
    • $100mm credit facility funded by an institutional lender, to be drawn in three tranches, $49mm of which will be available to be drawn down in the first tranche at a closing expected to take place sometime in February 2020;
    • $50mm private loan transaction, which will be partially funded by Acreage’s CEO Kevin Murphy, to provide cash collateral for the $100mm credit facility mentioned above; and
    • $30mm private placement of special warrants (an equity security often accompanying middle-market lending transactions as a “kicker”), along with an option to acquire an additional $20mm of special warrants.

These recent moves to secure credit by major players in the industry are indicative of an evolving and growing trend in the sector’s capital markets.  While many await the launching of cannabis-specific private equity funds and other similar financing vehicles, the need to stop-gap capital shortages in the near term will conceivably push cannabis businesses to consider the use of credit products at an ever-increasing rate.  However, as is the case with the limited equity capital available to the industry, since there is a notable scarcity of lending institutions that are willing to make loans to cannabis operators and a shortage of cash with which to make such advances, creditors will have substantial bargaining power and be able to extract terms (interest rates, covenants, collateral packages, etc.) that are much more comparatively favorable than those normally seen in non-cannabis deals, at least for the time being.  Therefore, as much as this is a boon for cannabis lenders, in their ability to close on secured credit facilities with double-digit interest rates, it is equally important for cannabis borrowers to fully understand and appreciate the impacts of entering into a credit arraignment and each debt facility’s related terms, associated costs of capital, and the tax/accounting implications of 280E.