Distressed debt lenders see the beleaguered cannabis market as attractive right now, but investors may want to be wary of marijuana companies embracing this strategy.
Nearly a year after the cannabis sector hit astounding highs in the spring of 2019, it has been beaten down by poor quarterly results, a vape health crisis and shrinking investor excitement.
But while the industry is now bruised, one investment fund thinks cannabis is more attractive than ever.
The partners at cannabis-focused fund Altitude Investment Management are applying their experience with distressed debt investment in order to pursue an edge in the burgeoning industry.
Roderick Stephan, a partner at Altitude and the co-founder of Distressed Investments Group at Citadel Investment Group, told the Investing News Network (INN) that distressed debt is debt trading at a discount because a company is in dire straits.
He believes cannabis offers a unique angle when it comes to distressed debt investment. Unlike companies in other general sectors that fall onto hard times because of too much debt and falling behind on interest payments, cannabis companies are beholden to different financial obligations.
“They build up a cost structure that is simply too expensive,” Stephan told INN. “Instead of having to restructure because of a debt load that they can’t handle, these companies have cost structures, salaries, leases, delivery obligations that they can’t meet, because they have negative cash flow and they need more money.”
Unfortunately, seeking capital in the marijuana space has proven to be a difficult task as of late with the souring sentiment surrounding the current state of the capital markets.
That’s where distressed debt lenders come in, he said. These lenders are not willing to invest with equity, and instead put debt onto the balance sheets of companies with high cost structures.
It’s not a tactic that’s open to the average investor, however, Stephan said, as it requires experience dealing with companies nearing the brink and massive amounts of capital.
What’s more, he warned that cannabis companies considering going down this path could be stepping into a precarious position. “It is the lender of last resort,” he said — only to be used when the capital markets aren’t available anymore.
“The entire venture capital private equity world in cannabis, is hunkering down, battening down the hatches and preserving capital for the best opportunities,” he continued.
Stephan explained that as Canada went online with legal recreational cannabis, investors flooded the space because Canadian firms were essentially the only public plays available; this heavily inflated values towards an inevitable bubble burst of sorts. The ripple effect of this event, coupled with a small retail sector and federal regulations, stymied the growth of the sector in the country.
While the US is ripe with upside, its investment landscape has also seen problems from major events such as the vaping crisis last year that was mostly related to unregulated accessories; it dented investor and consumer trust. Additionally, a large amount of uncertainty remains given the unclear timeline for a potential nationwide legalization platform.
All of these events have left the marijuana space in fairly bad shape and have applied pressure on existing firms trying to build profits.
Because of that, Stephan argued that distressed debt investment is a win-win scenario available for investors who can apply the strategy.
After a lien is first put on an asset — in the case of cannabis, largely cultivation and production real estate or dispensaries — at a loan-to-value ratio, the lender is guaranteed to get the total of their loan back, even in the event of collapse or insolvency at the company.
And if a company can pull itself back from the brink and begin to perform well, the investor will have saved equity and will get the chance to exercise the warrants they would have been awarded, diluting the existing equity investors.
Stephan noted that investors may decide to take over a company’s board and operations if it underperforms, slowly bleeding it of resources over time.
“In the cannabis space, the lack of hard assets in many of the branding companies, the distribution companies, any IT and software companies, (means that) if things start going bad, value can dissipate very, very quickly,” Stephan told INN.
In his view, companies with hard assets, such as cultivation and retail assets, are better suited for this kind of lending.
Stephan said, there isn’t an exact level of distressed debt Altitude is targeting. However, he always looks for management teams that are realistic about their financial problems.
“I would say I have never seen a set of management projections that I didn’t love,” he said. “For us to be able to come in and work with a company, management’s going to have to temper their vision and start coming down to Earth and be real.”
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Securities Disclosure: I, Danielle Edwards, hold no direct investment interest in any company mentioned in this article.
Editorial Disclosure: The Investing News Network does not guarantee the accuracy or thoroughness of the information reported in the interviews it conducts. The opinions expressed in these interviews do not reflect the opinions of the Investing News Network and do not constitute investment advice. All readers are encouraged to perform their own due diligence.