Why debt financing is on the rise

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Editor’s Note: This article was originally published on Cannabis time‘site with headline, “Debt Markets and Cannabis Businesses Lie.”

We are all in debt. If you owe nothing to anyone, you are not contributing to the The International Monetary Fund estimates household debt at $60 trillion.

Yet, as a citizen of a sovereign nation or even a resident of a small town with a water tower to pay, you are responsible for some of the $120 trillion in public sector debt traded in the markets. global bonds. The IMF calculates that there is roughly the same total of debt securities issued by non-bank corporations around the world. For comparison, the total market capitalization of all global stocks are only around $93.7 trillionaccording to the World Bank.

In other words, debt isn’t just a big deal. It’s the biggest deal.

There are reasons why debt financing has become so much more attractive to issuers than equity. Some involve internal company drivers, the founders’ desire to maintain control, for example. Some engines are external, both regulatory and economical.

“[A] U.S. tax code quirk favors companies with capital structures that lean towards debt rather than equity,” according to American Estate & Trust. “Interest payments are tax deductible; dividend payments are not.

Whereas Internal Tax Code Section 280Eas enforced today, prohibits cannabis businesses from deducting this interest and many other standard expenses, it all depends on cannabis the classification as a Schedule I drug and the obscure legal definition of “trafficking”, according to the Congressional Research Service. So it was only a matter of time before the cannabis industry shifted from equity to debt as an emerging funding source.

Debt financing [in the cannabis industry] reached their highest percentage level since we started tracking these stats, reaching 44% of total dollars raised in 2021, up from 38% in 2020,” wrote Viridian Capital Advisors President Scott Greiper and SLB Capital Advisors Principal David Rosenberg in Cannabis time in March. “Debt capital raised increased to $5.62 billion in 2021 from $1.65 billion in 2020. Seven of the year’s 10 largest capital raises were debt transactions.”

Part of this has to do with the dynamics specific to the cannabis industry. Over the past year, share prices among the peer group leaders have declined, weakening their appetite to raise more capital in the equity markets. Tellingly, Canopy Growth Corp., which has the biggest debt issue in the industry so far this year with a $750 million bond, saw its share price plunge 45.40 $ in February 2021 to a recent close of $5.79 at press time.

The Cannabis Debt Market

When an industry is in its infancy, it may attract the kind of risk-takers who prefer an equity stake in financial markets. Once established, it can target the lower end of the capital stack.

Investors who provide debt financing care little about the potential upside of ownership and instead seek a steady return through booms and busts. Apparently, cannabis has passed this milestone.

“More and more companies are mature enough to generate cash flow,” which bond buyers find attractive, according to Greiper. “They also have real estate, equipment and other assets to put up as collateral.”

Yet not every institution that would consider lending to producers can do so.

The problem is the legal gray area in which cannabis cultivation takes place: protected by state law, but still criminal under federal law. While Washington has shied away from cracking down on the deals, banks that are insured and regulated by federal agencies are avoiding underwriting industry bonds just as they are avoiding offering standard commercial loans. Legislation allowing access to banking services has been passed by the House of Representatives and is stuck in the senate. Even borderline usurious choices such as factoring or merchant cash advances are difficult to arrange, although Fundera lists some sources.

The primary source of debt funding, by default, is privately placed bonds. As their name suggests, they are not traded on an exchange, at least not when they are issued; a secondary market may or may not emerge.

The Securities Act of 1933 sets the rules for stocks and debt securities in the United States with the presumption that they will be traded on exchanges, in part by non-experts who are not financially savvy. To begin with, these instruments must be registered with the Securities and Exchange Commission, which involves a lot of money and a commensurate amount of time completing the paperwork. There are, however, permitted ways to issue shares or bonds without registration, so long as the purchasers are mainly, if not entirely, what is considered accredited investors. Anyone who knows precisely which qualified investors invest in a specific private placement does not tell. But they are almost certainly not banks, and they are unlikely to be funds that must adhere to a fixed charter.

“I expect most of the money [funding cannabis private placements] comes from unregulated companies and wealthy individuals,” according to Franklin G. Snyder, a law professor at Texas A&M University who teaches a course on cannabis business law.

These exemptions reduce reporting requirements and therefore the time and expense required to access capital markets. The rule governing private placements under the 1933 Act is Regulation D.

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Details of the private placement

A potential issue – for example, a licensed cultivation company or a multi-state retailer – would electronically file a short Form D when listing their securities. It is not a formal prospectus and does not involve any financial disclosure. Even so, a brief prospectus—called a private placement memorandum (PPM) in the trade – is usually attached.

A PPM should include:

  • offer terms,
  • Company Description,
  • biographies of managers and main shareholders,
  • the use of profits,
  • warranty (if applicable),
  • description of titles and
  • risk factors.

Reg D’s Rule 504 allows microcaps to solicit investment.

Rule 506(b) and Rule 506(c), on the other hand, apply to established entities that choose not to trade on an exchange.

In addition to the federal rules, most states have what are called “blue sky” laws which vary from state to state, although the standard model is the Uniform Securities Act.

Reg D Rule 144A provides protection against registration requirements for private resales, providing liquidity to the secondary market. Although this is not explicitly focused on debt as opposed to equity instruments, debt accounts for the bulk of the volume. 144A securities trading on the Nasdaq Private Market Solutions Platform.

If a guarantee is pledged as part of a quotation, the PPM must also mention this. In the cannabis space, real estate has the most tangible and easily monetized value. This poses another important consideration when listing securities: Cannabis is the most profitable crop in the market, but if a company were to face foreclosure, creditors are likely to have little interest or expertise. in the cultivation of these plants. They could require issuers to have the property appraised twice, both as a current operation and for its highest and best cannabis-free use.

And collateral will almost always be pledged because cannabis is, despite its enviable cash flow, a risky business just because of its regulatory environment. Even Canadian insolvency trustees have little legal leeway to monetize inventory. According to Snyder, US bankruptcy courts cannot touch it. He notes that companies can get around this problem by separating product and real estate into separate legal entities.

Even with this guarantee, however, there is a risk premium to be paid. While debt can be cheaper to raise and maintain than equity, cannabis debt isn’t cheap compared to prime debt.

“Nobody looks at them [cannabis company] obligations and confusing them with those of General Electric,” says Snyder.

The lowest interest rate one can hope for at this time can be deducted from the 7% note that Pelorus Equity Group cannabis real estate investment trust (REIT) issued last year when interest rates were significantly lower. Pelorus is using the $42.2 million raised to lend, presumably at higher rates, to its portfolio companies.

Cannabis companies typically don’t get investment grade ratings from Standard & Poor’s or Moody’s bond raters (Viridian offers an industry-specific rating scale), and investors typically don’t commit not in private placements for any return less than 10% at an absolute minimum. Exploitation of stems the recent raise of a modest $500,000 offered a 10% coupon, according to Viridian.

William Freedman is a freelance writer specializing in finance and technology. He holds an MBA in International Business from American University and serves on the Board of Governors of the New York Financial Writers’ Association.


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