The financing constraints that many cannabis operators face are a familiar story. Much revolves around impediments from lack of legalization at the federal level; however, other traditional drivers play a role as well, including industry and business life cycles. In recent months, the convergence of a number of factors, including increasing amount of capital providers, stronger credits and a low interest rate environment, has resulted in an emergence of debt financings and, in some cases, lower borrowing costs for operators.
Recent Cannabis Debt Financings
Over the last six to eight months, some larger multi-state operators have benefited from lower interest rates, achieving attractive financings with a sub-10% interest rate. For example, Green Thumb Industries announced a senior debt financing on April 30, 2021, where the company was able to refinance existing senior secured debt with a $217-million senior private placement at a 7.0% interest rate. Most recently, Ascend Wellness closed a $210 million Senior Secured Term Loan at 9.5% on August 30, 2021.
While these rates indicate an attractive progression in debt pricing and availability to the sector, they are not achievable for all operators due to various factors including credit size, potential collateral, credit quality, revenue concentration, profitability levels, capex requirements, among others. Borrowing costs have come down significantly, yet despite some recent exceptions, rates still range between 12-20%. The main factors influencing the rate cannabis companies can get are credit size and potential collateral.
Why have rates come down?
Many perceive that the U.S. is inching toward legalization, providing lenders comfort in business model as compared to previous years.
Aside from the prospect of federal legalization, more lenders are entering the space, which provides more supply for dollars. While the exact data is opaque on how many banks and credit unions have jumped into the cannabis industry, more and more institutions are gaining comfort in the industry, at least anecdotally.
One of the more overlooked elements potentially explaining why rates are coming down in the sector is simply that cannabis operations and credits are much stronger than they were a few years ago. Larger businesses provide more of a cushion to shorter-term swings in demand and can provide a lender with comfort on the ability to meet payments. As compared to a few years ago, many (though not a majority) of today’s businesses have moved from being cash consumers to cash generators. These firms also now have additional assets that can be used to secure debt, such as material receivables, inventory and fixed assets.
Additionally, as the cannabis industry has grown in social acceptance, firms at scale have poached talent from tangential industries to manage their growth, providing further comfort to corporate lenders with respect to professionalization of operations. A quick review of many top cannabis companies’ C-suite and board members reveals professionals from traditional industries such as consumer packaged goods (CPG); the same holds true for the financial control segments of these companies. As cannabis companies grow and evolve, expect available and increasing to further facilitate recruitment and onboarding of experienced talent from other industries.
Lastly, the cost of capital for financing providers (as opposed to operators) has declined substantially. One element contributing to this is the low interest-rate environment in which we currently operate. This factor, combined with strong equity market performance from public players in the space (e.g., IIPR and PowerREIT’s stock prices have increased >48% and >80%, respectively, year-to-date, although neither are plant-touching businesses) provides for an overall low cost of capital for these providers, which translates into the ability to provide more attractive financing.
As rates have come down, debt financings have increased
Since Q1 2020, the share of overall debt financings as a portion of total financings by dollar amount has increased materially, up from 16% in Q1 2020 to 85% in Q3 2021, according to data from Viridian Capital Advisors. The aforementioned factors play a role in this development—as larger, cash flow positive companies are able to be seen as credit-worthy, more lenders are entering the space, which lowers the cost of financing.
What we may have witnessed over the last few quarters is the surfacing of latent underlying demand for debt financing solutions in an industry handcuffed for capital solutions. The convergence of capital providers, stronger credits and a low interest rate environment has resulted in an emergence of these debt financings.
Equity Capital Raises
Per Viridian Capital Advisors, through Q3 2020 YTD, as compared to the same period in 2019, U.S. equity capital raises were up $342 million (+9%). Canadian raises, on the other hand, have declined materially, with equity raises down 49% for the same period vs. 2019. Top equity raises for 2021 YTD include cannabis technology platform Dutchie’s $350mm Series D round in October, following a previous $200mm round in March 2021; cannabis e-commerce platform Jane Technologies raised a $100-million Series C in August; and Kadenwood, a plant-based wellness company operating in the CBD space, raised $50 million of Series B fundraising in the same month.
Top public equity performers YTD in the include MedMen (up >75%), OrganiGram Holdings (up >69%), and Sundial Growers (up >38%).
Sale Leaseback Activity in the Cannabis Sector
From a transaction standpoint, five cannabis sale leaseback deals were publicly reported in Q2 2021, reaching more than $164 million in overall capital commitment (including additional committed funding).Q4 2019 remains the high-water mark for cannabis sale leasebacks at $314mm (11 transactions).
Sale-leasebacks comprise a small but material portion of the capital stack, ranging from 20% of deals (Q1 20 20) to most recently 7.5% (Q2 2021). As cannabis providers grow, become cash flow positive and increase in scale, we expect sale-leaseback financing to comprise a material portion of financing.
Sale-Leaseback Cap Rate Trends
“Cap rates” are real estate parlance for asset pricing. Similar to a bond yield, a lower cap rate implies a higher real estate asset price and from a financing perspective. In other words, a cap rate is an operator’s cost of financing.
Cap rates in the cannabis space have compressed significantly—while pricing is considered wide as compared to other sectors, given the capital constrained nature of the industry, a sale-leaseback can still be considered a relatively attractive financing alternative. Cap rates have declined from as high as 17% to the 11-15% range over the last couple of years. Alan Gold, board chairman for Innovative Industrial Properties, mentioned in the company’s Q2 2021 earnings call on Aug. 5, 2021, that rates compressed to as low as 9.5% in the most recent quarter.
Many have stated that the cap rate compression over the last few years has been due to the perception that legalization at the federal level is closer to becoming a reality. And, in fact, select deals have included an acceleration clause whereby the cap rate would compress should cannabis become legal at the federal level. However, the same fundamentals that apply to decreasing rates in the debt market (more pools of capital entering the space, low cost of capital from industry participants, larger credits seeking financing) all apply to the sale-leaseback market.
Cannabis Operator Perspective
What is the most efficient capital solution for a cannabis operator today? Much of that answer depends on what the comparison is, what assets are available to the firm to leverage and what lifecycle stage the company is in. In most industries the decision revolves around the benefit of leverage due to the tax deductibility of interest is weighed against the costs of a financial stresses from a fixed commitment; however, cannabis has its complexities here.
As any corporate finance discussion goes, equity financing is always more expensive than debt and dilutes existing shareholders. Debt is less flexible, but (in most industries) provides tax advantages. Sale-leasebacks can be strategically appropriate, but obviously only pertinent to where there is an owned facility element to the business.
The federal status of cannabis has put a kink in the traditional decision-making process and industry tax intricacies can provide further complications. Any operator seeking to optimize their long-term capital structure should consider all elements including overall cost of capital, tax implications, flexibility and dilution. Equity, debt and sale-leasebacks all offer various advantages, though the decision may be dictated by both company life cycle and industry nuances.
David Rosenberg, CFA is a principal with SLB Capital Advisors. Rosenberg has over a decade of investment banking and real estate experience, advising private and public companies on M&A, capital raises, corporate finance and capital structure.
Author note: Sources: SLB Capital Advisors, CoStar. Many thanks to Viridian Capital Advisors which provided traditional equity and debt financing data cited in this article.