Cannabis companies issued a sharply higher amount of debt in the first half of 2018 in a move by the industry to step up capital raising while adult use markets in Canada, California and elsewhere gear up.
A total of $1.2 billion in debt via 52 transactions was floated by public and private cannabis companies in the six months ended June 29, according to data from Viridian Capital Advisors, the New York-based cannabis-focused advisory and investment banking boutique. That's up more than 5 times from $200 million via 41 deals in the year-ago period.
Much of that debt came from one company: Smiths Falls, Ontario-based cannabis cultivator Canopy Growth (CGC) , which sold a whopping $460 million in convertible notes in a deal that closed on June 20. A spokesperson for the company did not comment on the company's debt offering, which was handled by Cowen and Co. and BMO Nesbitt Burns as joint bookrunning managers. A Cowen spokesperson declined to comment.
Other big convertible debt deals in recent months include Aurora Cannabis Inc (ACBFF) with about $264 million, followed by $88 million for OrganiGram Holdings Inc (OGRMF) and $76 million for Cannabis Wheaton Income Corp. (CBW.V) .
Harrison Phillips, vice president at Viridian Capital Advisors, said the increased activity reflects the growth of cannabis cultivators and retailers as they generate significant and expanding cash flow to fund more debt.
Convertible debt offers an alternative structure for investors through which they sit above equity holders in the capital stack and are entitled to real assets and equipment if the company defaults. Debt holders can convert their debt into common stock as the issuer grows its business.
"It allows investors to participate on the upside while also maintaining that downside protection with debt," Phillips said. "For a really, really early business there probably isn't the cash flow available to fund the debt -- that's why venture capitalists will usually get preferred equity in a start-up."
Larger family offices have taken the lead as buyers of cannabis convertible debt, rather than pension funds and other big institutional LPs, Phillips said.
Some of the regulatory issues around cannabis are keeping some investors at bay. But that's not the case with some family offices.
"Multi family offices... are typically only beholden to the head of the family and they can make decisions more quickly," Phillips said. Convertible debt offers a better alternative for investors because they sit above equity holders in the capital stack and are entitled to real assets and equipment if the company defaults. Debt holders can convert their debt into common stock as the issuer grows its business.
"It allows investors to participate on the upside while also maintaining that downside protection with debt," Phillips said. "For a really, really early business there probably isn't the cash flow available to fund the debt -- that's why venture capitalists will usually get
preferred equity in a start-up."
Toxic conversion ratios
The convertible debt typically offers interest rates of 4% to 7%, plus a conversion ratio to change the debt into common shares of stock.
David Feldman, partner at Duane Morris, said some cannabis companies have been including "toxic" terms that may benefit bond holders at the expense of the issuer. Among these are conversion ratios that adjust if the stock price falls, which helps investors if the value of shares go down.
More recently, however, such terms that favor bondholders have given way to better terms for issuers.
"As these companies have become more successful and stronger investment banks enter the space, we have seen less of the toxic deals and more that have no price adjustment or a floor below which the conversion price cannot go," Feldman said.
Derek Peterson, CEO of Terra Tech Corp, said convertible debt offers investors the security associated with debt with the flexibility to convert to equity if the market opportunity presents itself as attractive.
Last month, Terra Tech raised $5 million by selling senior promissory notes offering 7.5% interest and convertible into common stock.
The convertible debt also provides a cheaper source of capital than issuing straight common stock, he said.
"For publicly traded companies, generally the straight equity deals are going to be at a deeper discount to the average market price of your current stock," Peterson said.
Matt Karnes, managing partner at GreenWave Advisors, said issuers of convertible debt face the risk of dilution of their stock and potentially a loss of control of the company. Investors also face dilution risk if too much debt is converted to common stock at a time of slack demand for common equity.
Looking ahead, the pipeline for the rest of 2018 remains robust and ahead of year-ago levels, market sources said.
With larger investment banks such as Cowen and BMO Nesbitt Burns now in the game, cannabis convertible debt deals continue to gain institutional support. With adult use sales in Canada beginning in October, and adult use markets in California, Nevada and other U.S. states launching, more debt transactions in the space seem likely.
"As financial institutions are given more clarity on cannabis regulations and as cannabis company balance sheets scale up, we'll likely see more use of debt capital," said Phillips of Viridian.