Cannabis Musings - August 1, 2023
Structured Products x Cannabis = Fun!
Friends – I’d first like to recommend an excellent, long-form article by reporter Chris Roberts about former California cannabis darling, Flow Kana. Published last week in Alta Journal, a broad-based publication, it chronicles the cautionary tale of one of the biggest failures in California cannabis, which is also the story of so many companies from that first wave (about 2016-2019) of cannabis investor exuberance. It’s an article that, if I were a journalist, I would have written. Az me ken nit vi me vil, vellen vi me ken (“If you can’t do what you like, like what you can do.”)
On a different note, earlier this week, lender Pelorus Capital Group announced the first-ever securitization of cannabis loans. This is one of my favorite finance topics because securitizations, a subset of “structured products,” are creative, arcane, hilariously complex, and opaque. Even the term “structured product” is intimidating. When I was at Sam Zell’s Equity Group Investments, we worked on a wide range of structured products transactions, so when I saw that someone finally securitized a pool of cannabis loans, I kvelled.
Pelorus’ press release doesn’t really tell the story of these wonderful investment vehicles, so I thought I’d give some background. If you’ve seen The Big Short (2015), you’re already a little familiar with structured products – that movie told the story of the debauchment of residential mortgage-backed securities (as explained by Margot Robbie in that famous scene), which are another form of securitization.
Let’s say I’m a lender to a group of different CBD knish companies. I’ve lent out all my capital to these companies, and I’ve got a pretty good stream of interest and fees coming in, but I don’t want all of my capital tied up in these loans. So, I create a new entity (a “special purpose vehicle”), into which I contribute all of the loans. That entity now has cash flow from the interest on the loans, so the entity issues bonds (known as “collateralized debt obligations,” or “CDOs”) to investors, at an interest rate that reflects that cash flow. The entity uses the proceeds from the bonds to pay me back for the loans I sold to the entity, and I get fees from both managing the pool of loans for the entity and (possibly) from the borrowers on the loans for “servicing.” I now have more money to lend out to other infused knish companies and a nice fee stream.
Simple, nu?
There are a few things that make these a lot less simple. First, the securitization vehicles (the “entity”) tend to issue different “tranches” (a fancy finance term that basically means classes) of bonds, each with a different level of risk (which is then rated by a ratings agency) and interest rate reflecting that risk. The tranches are allocated so that, if the loans were liquidated (sold off), the least risky tranche would get its principal paid back first (and so has the lowest interest rate), while the riskiest tranche would get paid back last, if at all (and so has the highest interest rate). Any residual money left in the entity would get paid to the holder of the entity’s equity, which, under federal laws passed after the 2008 financial debacle (see, e.g., The Big Short (2015)), managers of these products can’t sell off the equity risk.
All of this is structured based on financial modeling and projections, and assumes a certain percentage of the loans don’t get paid in full. Because financial modeling is essentially highly-educated guessing (unless, of course, you employ scapulimancy), things never quite go as planned. Some loans get paid off early. Some loans go into default unexpectedly and stop paying interest. Some loans perform better than expected. So, the math needs to account for these changes over time.
It then gets even more complex when you start building in things like insurance wraps, credit default swaps on the bonds, synthetic CDOs (where the loans that make up the asset pool are replaced with credit default swaps (don’t ask)), CDOs of CDOs (where you take a bunch of CDO bonds and pool them into one CDO, because the leverage isn’t high enough; also known as CDOs2), and my very favorite: synthetic CDOs2. This is all taking an already complex, yet basic financial product, and then hyperextending the risk and leverage to generate fees.
Pelorus took a much more straightforward route. They reportedly issued a single tranche of bonds on a cannabis loan asset pool (they don’t disclose the interest rate – it’s only referred to as a spread (amount) above a global benchmark rate). They’ve reduced their own risk, because now they don’t own the loans themselves – the entity that purchased the loans and issued the bonds to the investors now owns the loans – but they get to continue to generate fees for servicing the loans, and now have more capital to invest elsewhere. It’s a tidy structure, and it’s good to see yet another tested tool utilized to normalize the industry.
Be seeing you!
Hauser Advisory provides advice and strategy on business lifecycle events and cannabis industry navigation, tapping into a deep, national network and twenty-five years of dealmaking and capital markets experience.
© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form.
Very informative, Marc!