Cannabis Musings - July 17, 2024
XS Financial proves me wrong.
Friends – there are some things that these Cannabis Musings have predicted with uncanny accuracy over the years:
SAFE(R) still not passing
the slow, steady movement of the alcohol industry into cannabis
the threat to so-called intoxicating hemp by the 2024 Farm Bill
the dearth of distressed cannabis M&A
a low-grade fardross continuing to plague the industry
(I’d link to older installments, but, unfortunately, they’re not available online)
Sadly, we here at Cannabis Musings are not perfect, which is why this newsletter is never legal, investing, or other advice on which you may or should rely. Case in point: you may recall that, a mere three weeks prior, on June 27, 2024, we talked about the following:
None of this means that going private for a public cannabis company isn’t possible. I’m confident there are scenarios where the facts line up and it can be done. I just don’t think it’s terribly feasible given all of the barriers to entry. And when you layer in all of the roadblocks that make distressed M&A particularly challenging in this industry, it’s even harder.
Well, it turns out that a mere three days prior - June 24, 2024 – XS Financial, a specialty finance lender to the cannabis industry, announced its own going-private transaction. Which I missed. Azoy gait es! (“So it goes!”). Now, to be fair to myself, when I wrote that June 27 installment, I had in mind plant-touching companies, but a lot of what I said still applied to ancillary businesses, so I suppose that my prediction wasn’t terribly accurate.
XS Financial hasn’t yet posted the transaction documents publicly (as of Wednesday morning, July 17th), but we learn from the press release that the buyer is paying a cash purchase price of Cdn$0.05265 per subordinate voting share and Cdn$52.65 per proportionate voting share. Based on its latest public filings, there were 77,728,044 subordinate voting shares and 26,156 proportionate voting shares outstanding, the buyer is paying about $5.5 million Loonies, or about $4.0 million US Dollars. (Note that I’m ignoring the value outstanding in-the-money options and warrants for simplicity’s sake.)
We talked three weeks ago about what makes going-private transactions expensive – lawyers, accountants, lawyers, investment bankers, lawyers. The company appointed a special committee of the board to evaluate the transaction (probably because the senior officers and directors hold a large portion of the vote), which then hired its own lawyer and investment banker, the latter of which issued a “fairness opinion,” which, true to its name, says that the amount to be paid by the buyer is, indeed, fair. The company also has its own lawyers and investment bank, and the buyer has two sets of lawyers (US and Canadian, since XS’s stock is listed on a Canadian exchange). The accountants aren’t mentioned. I could be totally wrong here, but I’m guessing that’s well over $1mm (US) of professional fees, when you also include the drafting of the proxy materials soliciting the vote of the stockholders, the company that calls stockholders to get them to vote, etc. etc.
So, why then would the buyer here incur such a large cost relative to the purchase price in order to get this deal done? On its face, it doesn’t seem to be economically rational. Curiously, we don’t learn from the press release the identity of the buyer, but that’s disclosed instead on the website of Schulte Roth & Zabel, the law firm that represented the buyer. There, we learn that the buyer is Axar Capital Management, an institutional, middle market asset manager with $2.5bn under management.
I suspect that writing a $4-ish million-dollar check is fairly easy for Axar, so it doesn’t need leverage. Taking XS Financial private gives Axar a platform to put capital to work into the cannabis industry in the form of equipment financing (XS’s bread-and-butter), and I’m guessing that Axar’s cost of capital is much lower than what XS was able to access. “Cost of capital” essentially means the return that needs to be generated in order to make a profit. For debt, it means that Axar likely could borrow money to make those equipment loans at a lower interest rate than XS Financial could (lenders to cannabis companies, even ancillaries, like to charge juicy interest rates). For equity, it’s a little more complicated, but it generally means that Axar’s investors probably have a lower rate of return expectation than XS Financial’s stockholders.
In other words, I’m guessing that Axar sees this as a good opportunity to take a portion of its investors’ equity capital, as well as money its able to borrow from lenders at a relatively lower interest rate, and then lend that money out to cannabis equipment borrowers at a much higher rate of interest, making a nice, levered spread on a fairly secured basis. Not much different from the way any other lending business works. Axar probably views the relatively (percentage-wise) transaction costs of buying XS as a drop in the bucket relative to the potential opportunity, given its much lower cost of capital.
All this is speculation on my part, but when you consider the transaction from Axar’s perspective, the cost makes sense, and puts a dent into my prognostication. Nobody’s perfect.
Be seeing you!
© 2024 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. The foregoing represents my own views and not those of Jardín.